Option contracts
Many say Buying
and holding stocks strategy is
the way in building wealth, well, just this strategy doesn’t help you generate
income so personally To understand the one and only win option strategy listed in this book. It is
very important to understand the basic foundations of option
Let’s start with an option. What is option.
It’s a choice.
Let me explain with an example
Let say you want to sell your property for
$100,000 and I am looking to buy properties for low prices to sell higher
prices for profit. So, I am not sure to buy your property, so I pay you $1000
for the option to buy it from you but not obligated for a period of 2 months
while seller waiting in closing the sale, contracts protects him against any
decrease prices in property for period of 2 months. Meanwhile I keep looking
for other properties the Option contracts protects me against any Factors like
rise and fall of housing market. if find
no properties that takes my interest, I will exercise my option contract and
buy it from you for $100,000 before end of the period, so I paid you in total
of $101,000 (includes option fee and for property) your primary responsibility
as a Seller is to deliver the assets or property to me up on option exercised. Later
I sell the property for profit say $120,000 reaping $20,000. If I hadn’t made
the sale, as a seller you would keep $1000 as a fee or premium I paid for you
for option contract and I would lose $1000 and let the option expire
worthless. In real world, Option
contracts works in similar fashion with Calls and Puts.
Call option: An option that
grants the holder the right but not the obligation to buy the underlying at a
predetermined price. The buyer of a call is expressing a bullish
(optimistic) view of the underlying stock, an increase in price of an
underlying stock bring the profit for a call option buyer. The risk of being a call
option buyer is with the decrease in underlying stock, chance of losing all the
capital invested or the premium paid to the seller.
If X thinks a stock ABC currently trading at
price $25 speculates it could reach to $50 with in next 3 months buys an Call
option for $200, which means X has a right to buy 100 shares of ABC for $25 any
time with in next 3 months but not obligated to. If as speculated stock reach
to $50, buyer exercise the option and sells it in the market for $50 for profit
of $25 a share. If the stock had not gone up, buyer simply let the option
contract expire worthless and his total loss would be the premium paid to the seller
($200) , instead of buying 100 shares and suffer loss in times of decrease of
the price in stock, its better off just to buy call option and limit the loss
with premiums paid.
What is put Option?
Let say a
stock ABC is currently trading at $80, sudden change in management or
due to other market factors you think that the stock is overvalued and will
decrease to $65 , Instead of selling it
short at $80 with an unlimited risk, you buy a put option at strike price $80
for 1 month for $100 ($1*100 ) per
contract , before the expiration of your option the stock breaks to $60 and put
trades at $4 . you can close this
position either by selling the put or by exercising it in the open market, If
the option trades at $4 (4*100) my
profit in selling the put is $300($400-$100) . If I choose to exercise in open
market, I would buy shares for $60 (60*100=$6000) and then put(sell) shares at
$80 as I have right to sell with profit of $2000 (($80-60 )*100). Here my
Maximum loss of premium $100 would be if stock price increase above $80 and
maximum gain is if stock price is below $79 ($80 strike price minus the premium
paid)
Why Options?
They
give the holder an unlimited chance for profit with a fixed and limited loss. Options can be used for various reasons such
as to protect a profit, protecting your assets in times of declined market, purchasing
call options is much inexpensive than purchasing 100’s of shares thus minimize
your initial investments.
How option protect your stocks portfolio: Suppose
you own 100 shares of XYZ purchased
at $20 a share now selling price in the
market is $25. But you think stock has potential to go much higher later though
it has down side for short period of time due to management change or new
product launch, nevertheless, he would not lose the profit he has now so you
can buy a put at $25 for 90 days, which will cost him about $200
per put contract , If at the end of 90 days the stock is selling at abandons
his put-option contract, and he is free to stock at 10 points additional profit
or not, as he sees By having the put, he increased his profit by 10 against a
cost of $400 for the 90-day protection. the other hand, the stock had declined
to 50 during of the put, he would have delivered his stock at 75 the put
options, instead of selling his stock in the at 50. Another useful function of
the call option: Consider position of a man who has bought stock at 30 and that
it is now selling at 20. He would like to buy an additional stock at 20 to
average, but he has neither the age nor the desire to take the financial risk.
Instead of buying additional stock, he buys a call at 20, good for 90 days, for
which he pays $200 per hundred-share call. He knows that the additional risk in
trying to average is limited to the cost of the call. ever, if the stock should
advance to 30 in the 90 days the call contract, he can sell 200 shares at 30 -
the stock that cost 30 and the hundred that he can through his call at 20. A
bad trade turned into profit by a limited risk of $200 for the call option! It
might be well to point out that the premiums for put and call options vary
according to the price stock in question, the length of the option, and the
tility of the stock. Calls on Radio selling at 38 would not cost as much as
calls on General Motors selling at 93 not would a 90 -day call cost as much as
one for six months ten days. All options that are sold by members of the Put
and
The options contract: - 100 shares of stock is
referred as 1 contract
example: XYZ stock is trading $40/share.
Say
XYZ July 45 call is trading for $1(in premium or a fee )
For single
contract (100 shares of XYZ ) the cost
would be $100 (1*100=$100) + commissions,
Up on option exercised, The shares can be owned for
$45/ share or $4500
From the examples we see Options contracts have an
expiration date, after this date, any outstanding options held and not exercised
become worthless. Some 90 percent of options expire worthless.
Strike Price or Exercise Price: It is a Specific price
at which underlying stock shares can be purchased or sold, it is a fixed value
and is not affected with share price increase or decrease.
Example.
Buy XYZ 1 June 25 Call:
this statement
means a buyer purchase a 1 call
option contract ( 100 shares ) with an
expiration date till June 25th at STRIKE PRICE or Exercise
price $25
If you want to exercise that Option, You would
pay a share $25 *100 for I contract ( $2500 excluding commissions to buy 100 shares ) any
time till the expiration date ( June 25th)
Sell XYZ 1 June
30 Call
Sell a call
option on shares XYZ with the expiration date June at strike price @30 ;
If Option
exercised, the Call Option seller is obligated to deliver or forced to sell the
shares at price of $30 even if the stock is trading at $50.
Example
Sell XYZ 1 August 29 PUT
You are willing to sell XYZ of 100 shares at a predetermined price or
strike price at $29 till the expiration
date Aug 29
If this option is exercised, The option seller or
writer would have to buy 100 shares of XYZ
from option buyer for $29/share
or $2900 ( commission excluded ) from price 0 – $29)
with in the expiration date.
Options In
the Money (ITM), at-the-money (ATM ), or
Some time
An option can be :
in-the-money ( ITM ), or
at-the-money ( ATM ), or
out-of-the money ( OTM ).
in-the-money ( ITM )
.
For call options, an in-the-money call is one
where the stock price is above the call strike, so it has a positive intrinsic
value.
Example
At-the-money calls have the same or nearly the
same strike price as the stock price,
Example
out-of-the-money calls have a strike price well
above the stock price.
Example:
The opposite is true for puts. In-the-money
puts have a strike price above the stock price, at-the-money puts are still
near the stock price, but out-of-the-money puts have a strike price well below
the current stock price.
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