Option put and call examples
But before I begin, I want to again give a big word of caution. Options are complex financial instruments. Using options is kind of like using dynamite - useful, but dangerous to a beginner. Don't dabble in it unless you really now what you're doing. Let me first explain what put options are. Holding a put option gives you the right to sell a stock at a fixed price. This fixed price is called the 'strike', and the prices of put options differ for various strikes.
As with call options, put options also have expiries. The price of the put option again differs for various expiries. To put it one way, put options are the opposite of call options that we explored last time. Whereas call options give the holder to right to buy at a fixed price, put options give the seller the right to sell at a fixed price.
You make money on put options when the stock price goes down. On the other hand, if the stock price ends up above the strike, then the put option becomes worthless. This last fact means that you can lose every penny you put into buying put options. In fact, this routinely happens. For this reason, buying put options is dangerous business. If call options can be thought of as borrowing money to buy stock, put options can be thought of as insurance. If you buy house insurance, you pay out a monthly premium.
As long as your house doesn't burn down, you don't benefit from having the insurance. You eat the premium you paid as a loss. However, if your house does burn down, you gain above and beyond what you paid for in premiums.
Now, suppose you own shares of GE. You hold GE stock because you believe in the company. However, you're a little nervous about what's going to happen to the stock in the short term. To alleviate your anxiety, you can buy put options.
In effect, this limits the extent of your loss to just the amount you paid for the put options - i. Also, like insurance, if the bad news never comes and GE goes up, you don't gain anything from having insurance.
You'll just have eaten the insurance premium as a loss. While put options and insurance are very similar, they do have one difference. Whereas you can only buy insurance on what you already own, you can buy put options on stocks you don't own.
If the stock falls in price, the put rises in price and helps offset the paper decline in the underlying stock. If you don't own the stock but think it will go down in price, you buy the put to profit from the decline in price of the stock. If the stock price declines, the value of the put rises and you would sell the put for a profit.
If the stock increases in price you may sell the put for a loss. A put option is a contract that gives you the right, but not the obligation, to sell a stock at a preset price. The price that you pay for a put option depends the duration of the contract the longer the duration, the more you pay and how far the current price of the stock is from the strike price of the contract. Put buying is different from selling short.
With a put option your only liability is the price you paid for the put. With a short sale, you have an unlimited downside liability if the stock goes up. Also, the proceeds from selling short are in a margin account so you have to pay interest and meet margin requirements. Buying puts is a more conservative way of betting on a stock declining in price. Selling a Call For every buyer of a call there must be a seller, who assumes that the stock price will remain flat or go down. The seller collects the purchase price of the option but has the obligation to sell shares of the stock if the buyer decides to exercise the option.
If the seller gets called - he must sell the stock. If the stock continues to appreciate in price after the stock is sold, the seller looses the future price gain. In most cases you must own shares of the stock for each contract you sell - this is called a covered call.
Therefore, if your stock gets called away, you have the shares in your account. You can sell covered calls to generate a stream of income. If the stock price does not rise enough during the period of the contract, you won't get called and won't have to sell the stock so you keep the money you received when you sold the call.
If your broker lets you, you may sell "uncovered "or "naked" calls in a margin account. This practice lets you sell calls when you don't own the stock. If you get called, you must buy the stock at its current market value to cover the call even when the market price is higher than the strike price of the option.
Like any margin account transaction, you must execute the transaction immediately. The seller of a put collects the purchase price of the option from the buyer of the put. The seller has the obligation to buy shares at the strike price regardless of the market value of the underlying stock. So if the put buyer decides to exercise the put contract, the seller of the put has to buy the shares at the strike price no matter the current market value of the stock.
When you sell a put, you want the price of the stock to go up so you don't get the stock put to you - buy the stock for more than it's worth. Selling a put places the money you receive in a margin account so you pay interest on the proceeds until the put contract is closed.
If you don't have the financial resources to cover the obligation of buying the stock from the buyer of the put, you sold "naked puts". It tells about a trader who sold naked puts and experienced financial ruin. It was an unhedged bet, or what was called on Wall Street a "naked put" On October 27, , the market plummeted seven per cent, and Niederhoffer had to produce huge amounts of cash to back up all the options he'd sold at pre-crash strike prices.
He ran through a hundred and thirty million dollars - his cash reserves, his savings, his other stocks-and when his broker came and asked for still more he didn't have it. In a day, one of the most successful hedge funds in America was wiped out. Niederhoffer was forced to shut down his firm. He had to mortgage his house. He had to borrow money from his children. He had to call Sotheby's and sell his prized silver collection Use calls and puts judiciously.
If you're right, you can make quick money. If you're wrong, you can lose part or all of your investment very quickly.