Buying a Call
You pay a premium for the right, but not the obligation to buy a stock at any time before the expiration date.
You also have in your contract the right to sell that contact ANY TIME before expiration date.
Your premium is known as “as risk.” You can lose all of this investment.
So in order to make money when we purchase a call option, the price of the stock must go up over the stock price + the premium we paid per share
Example of Buying a Call
1. On August 23rd you pay a 5K nonrefundable premium to buy my house for 100K on January 1st, 2008.
2. When Jan 1st comes, if my house is worth 150K, you have the right, but not the obligation, to buy it for 100K and sell it for 150k, resulting in a 45k gain using a 105k investment. This is a gain of 43%.
3. When Jan 1st comes, if my house is worth less than 100K, you do NOT have to buy it. You would lose the premium. You can sell that option if the price of my house begins to deteriorate after the contract is bought, for a small loss.
4. If anytime before Jan 1st my house is worth more then 100K, you can sell the contract and take the profit. Using the example above, we can sell the option for 50k and make a 45k profit. This is the beauty of options. You use 5k to make a profit of 45k (a 900% gain) instead of using 105k to make the same profit.You make the same profit without having to purchase and sell the equity. This is known as leverage.
Buying A Put
Same procedure as buying a call except you are betting that the stock will decrease in value. Profit is made once the stock price goes below the Strike price + the cost of your premium.
Selling a Put
You are credited the premium when you sell the contract.
As long as the stock stays above the strike price, the contract will expire worthless and you will make the premium.
So in order to make money, when we sell a put, we want the stock price to stay above the strike price.
You only sell Puts when you are comfortable owning the underlying stock (at a discount)
Example of Selling a Put
1. The current price of LEND is at $6 a share.
2. We sell the $2.50 strike price put for September. The premium on this sell is .80 cents per share (.80/share).
3. We sell 100 contracts (100 contracts * 100 shares = 10,000 shares).
4. The amount credited to our account for the sell is 10,000 shares X .80/share = 8,000 dollars.
5. As long as the price of LEND stays above $2.50, we get $8,000 on the expiration date.
6. Now what happens if the stock drops to $2.50? We have to buy the stock back!
7. We buy the stock back at the Strike Price – Premium.
8. For LEND that would be 2.50 - .80 = $1.70 per share.
9. The JUICY part is that when the stock fell to $2.50, we bought it at $1.70, which means that we can turn around and sell the stock at the market price of… lets say $2.45… and still make a sizeable profit (7,500).
10. (2.45-1.70) * 10,000 shares = 7,500.
Selling a Put
You are credited the premium when you sell the contract.
As long as the stock stays above the strike price, the contract will expire worthless and you will make the premium.
So in order to make money, when we sell a put, we want the stock price to stay above the strike price.
You only sell Puts when you are comfortable owning the underlying stock (at a discount)
Example of Selling a Put
1. The current price of LEND is at $6 a share.
2. We sell the $2.50 strike price put for September. The premium on this sell is .80 cents per share (.80/share).
3. We sell 100 contracts (100 contracts * 100 shares = 10,000 shares).
4. The amount credited to our account for the sell is 10,000 shares X .80/share = 8,000 dollars.
5. As long as the price of LEND stays above $2.50, we get $8,000 on the expiration date.
6. Now what happens if the stock drops to $2.50? We have to buy the stock back!
7. We buy the stock back at the Strike Price – Premium.
8. For LEND that would be 2.50 - .80 = $1.70 per share.
9. The JUICY part is that when the stock fell to $2.50, we bought it at $1.70, which means that we can turn around and sell the stock at the market price of… lets say $2.45… and still make a sizeable profit (7,500).
10. (2.45-1.70) * 10,000 shares = 7,500.
