Calls And Puts Are Not The Same
In the realm of stock options there are two types: calls and puts. They are nearly identical except that one is for buying and the other is for selling.
A call option is a tradable security that gives the buyer the right, but not the obligation, to buy a certain amount of stock by a known date for a certain price. A put option is the opposite: it gives the purchaser the right, but not the obligation, to sell stock by a known date for a certain price. The 3 main attributes: stock, date, price, are all agreed to in advance by both parties.
The ‘date’ of an option contract is the expiration date. It is the last day that the holder of the option can exercise his right to buy (for calls) or sell (for puts). After that date he cannot because the option has expired. When buying options it is important to keep this date in mind at all times — if the investor is expecting some price action due to an earnings announcement then he needs to make sure the expiration date is after the expected announcement date.
A critical attribute of any option is its strike price because that is the price that the two investors in the trade have agreed to. If the stock finishes above the strike price (for call options) on expiration day, or if the stock finishes below the strike price (for put options) on expiration day, then then holder of the option will exercise his right to buy (for calls) or sell (for puts) the stock. In the case of a call option, if the stock is below the strike price then it doesn’t make any sense for the holder to exercise his right to buy at the strike price; it would be cheaper to just go into the open market and buy shares at the market price. But if the stock was above the strike price then he would be better off exercising his option to buy the shares at the strike price.
The price of the option is comprised of two parts: time premium and intrinsic value. If the call option is out of the money (meaning the current market price is below the strike price) then the entire option price is time premium. But if the call option is in the money (meaning the current market price of the stock is above the strike price) then the intrinsic value is the difference between the stock price and strike price, and then the time premium is the difference between the option price and the intrinsic value.
Speculating with puts and calls is, well, speculating. Investors can make a lot and lose a lot in a relatively short period of time. If the investor is correct about a stock’s direction and timing then he can do quite well with call options or put options. However, most options held until expiration end up expiring out of the money (ie worthless) so many professional traders believe there are better odds in selling puts and calls to other people, rather than buying them.
Born To Sell’s site has a free tutorial and blog on covered call trading. The monthly newsletter on options contains articles income investors would enjoy.
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