How do Stock Options Work? Trade Calls and Puts – Part 1

by Darwin on August 10, 2009

Since I routinely post about stock options trading, investing, hedging and income generation and get the occasional question, “How do Stock Options Work?” or “How to Trade Stock Options“, I figured I’d do a series on the various types of stock options strategies out there (they are numerous!) by starting with the most basic stock option strategies: Trading put and call options.  I’ll start with some definitions and then get into some real-life examples.

Stock Option Trading Basics:

  • A Stock Options Contract is a contract between a buyer and a seller whereby a CALL buyer can buy a stock at a given price called the strike price and a PUT buyer can sell a stock at the strike price.
  • 1 Stock Option contract represents 100 shares of the underlying stock
  • Think of a CALL and a PUT as opposites.
  • You can be a CALL Buyer OR Seller
  • You can be a PUT Buyer OR Seller
  • Given Puts/Calls and Buyer/Seller status, there are 4 main types of transactions we’ll cover today – Put Buyer, Put Seller, Call Buyer and Call Seller
  • If you are an option buyer, you pay the listed “premium” for the option; conversely, as a seller of an option contract, you derive income equivalent to the “premium”

Key Options Terms are the following:

  • Strike Price: This is the key price that drives the transaction.  For a Call option, if the underlying share price is BELOW the strike price, the option is “out of the money” and if so at expiry, it will expire worthless.  For a Put option, if the underlying share price is ABOVE the strike price, the option is “out of the money” and if so at expiry, it will expire worthless.
  • Expiration: This is the last date the option can be traded or exercised, after which it expires.  Generally, there are options traded for each month and if they go out years, they are referred to as LEAPS.  The same concepts hold for LEAPS as the stock options contracts we’re discussing here.
  • Premium: This is just another word for the price of the option contract.
  • Underlying Security: For our purposes, we will be discussing stock options.  If you’re holding a contract on Microsoft, you have the right (but not the obligation) to exercise 100 shares of MSFT.
  • Buyer or Seller Status: If you are the buyer, you have control of the transaction.  You purchased the option contract and can execute the transaction or close it out or you can choose to allow the options contract to expire (usually only in the case where it is worthless).  If you are a seller of an options contract, you are at the mercy of the buyer and must rely on the holder at the other end of the contract.  There is the opportunity to “close out” the position

Stock Options Trading Example #1 – Call Buyer:

People trade stock options for myriad reasons.  Often times, it is purely for speculative reasons.  For example, if you believe that the Swine Flu pandemic is going to become particularly troublesome and a stock with a vested interest in supplying vaccines in large quantities would stand to benefit from such a scenario, then perhaps you purchase an out of the money call option on Novavax.  If shares are at $4.28 today and you think they could rocket past $10 on a massive epidemic, then perhaps you buy the January (expiry) 10 (strike) Call option.  The cost (premium) is .70.  The .70 is “per share” so .70*100=$70.  This means it’s going to cost $70 to buy a single option contract, plus whatever trading commissions exist.  Since you paid .7 or $70 and the strike price is $10 per share, by January expiry (the third Friday of every month), NVAX shares would need to be at $10.70 in order for you to break even.  In order to have made money (in lieu of commissions), shares would need to exceed $10.70.  If, for example, shares rocket to $20.00 at expiry and you sell the options back to close it out just prior to expiry, you’d pocket the difference between $20 and $10 and reap (10*100shares) = $1000.  Given your initial $70 investment, even though shares only went up about 5-fold from $4.28 to $20, the option returned over 14-times the initial investment ($1000/$70).  As you can see, utilizing these leveraged instruments can lead to big gains quickly.  However, most options actually expire worthless – about 2/3 by most conventional estimates.  There’s no free ride.  For everyone looking for a speculative home run, there’s a seller on the other side deriving income from a speculative buyer thinking that the stock WILL NOT reach the strike price they sold at, so they’ll get to keep that .7 at the end of the expiry in January.  Note that at the other end is a Call Seller which is often someone engaging in covered call option writing strategies – this can be a lucrative option strategy worth checking out as well.

Stock Option Trading Example #2 – Put Buyer:

When wondering if anyone actually made money during the economic collapse, the answer is a resounding YES!  People who were holding puts on Financial and Real Estate stocks especially, made large returns on investment given the precipitous declines in shares of those companies.  If for example, you feel we’re in for another economic calamity due to commercial mortgages collapsing next, and all Financials are going to fall, you could buy a Put option on the Financials ETF XLF, which is representative of the Financial sector at large.  With a share price of $13.34, let’s say you buy a Dec09 expiry Put with a strike price of $10.  That means that you expect the XLF ETF to drop well below $10 per share by December.  The premium (or your cash outlay) for such a play is .25, or $25 per contract.  That’s relatively cheap.  But keep in mind that you’re talking about a 40% drop to just break even.  If the XLF collapses and returns to its March lows of around $6 per share, your put would be worth about $4 at expriy (10-6).  That represents a 16x return on investment.  Imagine the players that had the foresight to buy out of the money puts in 2007 and 2008?

How to Trade Stock Options?

There are various online brokerage outfits that allow you to trade stock options. For most outfits, you can buy options without any special requirements. If you’re looking to sell options, because your risk is much greater (or unlimited for selling naked/uncovered calls), you generally need to sign up for a margin account and agree to risk notifications.

Here are the top online options trading brokerages based on reviews and costing:

1. optionsXpress – Awesome $100 Signup Bonus Running Now. Plus, $12.95 for 1,5, or 10 contracts – flat fee if hitting 35 traders/quarter. Otherwise $14.95/trade. A good price for newer/smaller options traders. Stocks are $9.95 per trade if greater than 8 trades per quarter or $14.95 for 8 or less trades.

2. Zecco – Another incredible pricing scenario -

Get 10 free stock trades every month with $25,000 balance or 25 trades each month $4.50 otherwise

3. tradeMONSTER – $7.50 Stock Trades across the board. $12.50 Options Trades for up to 20 contracts.

4. OptionsHouse.com – An incredible $2.95 Stock Trading Price and $9.95 Options Contract Pricing.

5. Tradeking is widely knows as best in class for service and cost. I endorse TradeKing and I have an account myself. $4.95 stock trades and competitive on everything from Options to Margin. Check it out!

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{ 13 comments… read them below or add one }

1 Earn Cash Now May 18, 2010 at 12:52 pm

I love TradeKing. I thought that I would never leave Etrade, but I was wrong. There is so much you can do and make with stock options. If you don’t use stock options currently then learn how to because you will make a killing with your little money that you have.

[Reply]

Richard Gulino Reply:

@Earn Cash Now, I am interested in learning about options and would be grateful for your teaching me..

[Reply]

2 Phil Cantor September 15, 2010 at 1:07 pm

Hi, I’m looking to invest in mobile app stocks and smartphone stocks. Can you provide any suggestions? So far I have SWKS, ARMH, MIMV, ZAGG, RFMD and NVDA from this list: http://www.wikinvest.com/wiki/Mobile_app_stocks but I need need additional positions. If there are any ETF’s with a focus on mobile that would be great too. Thanks – Phil Cantor

[Reply]

3 Bill Roberts November 15, 2010 at 2:50 am

Very useful. I think that options trading has great potential for the non-professional investor as well as the professionals. I think it is necessary to learn about some of the strategies beyond straight forward buying calls and puts. Is it realistic for the home trader to engage in selling options, or should he stick to buying only?

[Reply]

4 Al November 26, 2010 at 4:39 am

Than you so much for all of this great information. Your explanations on the ‘call buyer’ and ‘put’ buyer really helps. Another site that I have found to be very helpful for beginners is (www.optionsimple.com). Thanks again. You have helped me very much :)

[Reply]

5 شات April 15, 2011 at 3:16 pm
6 Wilfred Motosue February 19, 2012 at 2:01 am

Where can I find out the prices for put options? I would like to find out how much a put option cost if I had a strike price of the same amount that I bought a stock for and only need it for a short time say 5 days. I want to use it as insurance or protection that my stock doesn’t go below what I bought it for.
Thanks.
wilfred

[Reply]

7 شات April 26, 2012 at 4:19 pm
8 Chris May 30, 2012 at 9:39 am

Binary Options Trading VIDEO Tutorial – How To Make 75% Every 15 Minutes
http://youtu.be/Y23ToXJuA8k

[Reply]

9 Tom June 30, 2012 at 6:52 pm

Binary Options are a Scam to take your money. They are offshore and unregulated by the US. Don’t be fooled if you go to youtube also search for binary options scam. You can give them your money they will take it you can make $50,000 but they will never send you a dime. Also if you give them your personal info. Instant Identity Theft.

[Reply]

10 خلفيات بلاكبيري August 26, 2012 at 3:16 pm

thanks for the’s

[Reply]

11 Trading Options September 4, 2012 at 4:26 pm

Options are incredibly versatile and a great tool for the middle class to use in their portfolio. I am always surprised at how terrified the average person is of using options.

[Reply]

12 شات مصرى September 8, 2012 at 9:29 am

thanks for the’s

[Reply]

13 منتديات March 9, 2014 at 5:39 am

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[Reply]

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