Can anybody explain American Call and Put options

Discussion in 'Stock Market Education' started by Beautyspin, Jan 8, 2015.

  1. Beautyspin

    Beautyspin Member

    Jan 2015
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    Hi -
    I know I can get this info from Google too, but I would appreciate if anybody can explain the call and put options (w.r.t American stock markets only not the European and other countries). The reason I am choosing this place to educate myself instead of googling it because I feel I can come back with questions in case I do not understand the concepts.

    Hope you guys do not think this to be too basic a question.
  2. JR Ewing

    JR Ewing Super Moderator Staff Member

    Feb 2014
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    No question is "too basic" when money is on the line IMO.

    A call option is basically a small deposit on a long position on an investment (rather than actually buying the investment at full current price). You're basically making a small down payment on the stock or other investment that gives you the RIGHT (not the obligation) to own the investment at or before some point in the future (usually months away, sometimes years). Buying a call option is generally a bullish position - you're basically speculating that the price of the investment will go up a certain amount or higher at or before a certain date in the future.

    If the underlying investment goes up to or beyond that price before it expires, you can exercise the call option you bought and take ownership of the actual investment.

    1 Option generally equals 100 shares of stock on stock options.

    Option prices differ based upon expiration dates and factors relating to whether or not sentiment on the underlying investment is generally bullish or bearish during that time period. Calls will tend to be cheaper than puts with a similar expiration date if sentiment on the underlying investment is more bearish, since more people are thinking that the investment will go down in value during that time.

    For example, if you think the price of Priceline stock will hit $1200 or more between now and some definite time in the future from its current price of $1050, you could buy a call option representing 100 shares for a small fraction of the $105,000 it would take to purchase 100 shares of the stock. You'd probably be able to buy a call option for a few grand, sometimes less, depending upon the time frame and other factors.

    If the price reaches that point or higher before the option expires, you have the right to exercise the option and own the 100 shares and realize the $200 or more profit on each share - $20k or more in profit off one call option, minus the cost of the option. If the price didn't reach $1200 or higher before the option expired, the option is worthless - but you're only out the few thousand or whatever you paid for the call option, and you didn't have to tie up $105k during that time. But you still lost the $ you spent on the call option.

    A put is the opposite of a call - it's a small deposit on the right to short the stock. Buying puts are generally safer than taking short investment positions, since the upside of an investment such as a stock or commodity is theoretically unlimited... and you can walk away from ownership of a put option out only the small amount you paid for the option, rather than the loss you could suffer on an actual short stock position.

    One thing to be aware of is the difference between BUYING options and SELLING (aka "writing") options. When you sell options, you are OBLIGATED to deliver the underlying investment at a certain price at a loss to you if the option BUYER was right and you were wrong. You cannot walk away from the SALE of an option like you can a buy.

    The other difference with selling the option is that you pocket the cost of the premium from the buyer. But that premium saddles you with responsibility to deliver if you're wrong and the buyer is right.

    If you ever SELL options, they should be COVERED options - options you wrote against underlying actual long or short stock positions you already owned / borrowed, so that you don't take a big loss and hopefully can even profit at least a little.

    An example of SELLING a covered call: You bought Apple at $100, sold a covered call to someone when it was at $110 who thinks it will go up to $120 or higher within a certain time period. If the stock doesn't go that high, you pocket the money they paid you for the call option and you're done with it. If the stock does go to $120 or higher, you have to deliver, but you still made money because you bought the stock when it was even cheaper prior to selling the option.

    Options in general are an advanced strategy, and not really a good idea for beginners or those with limited $. It can be particularly hazardous SELLING options if you don't know what you're doing. Just as shorting stocks or commodities or being too concentrated in highly volatile investments can be.

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