Options Education

Buying Calls

If you think a stock is going to go up in price, you can buy calls. In general we buy a stock or a call option because we think it is going up in value; and, when it does, we sell the stock or option.

Imagine it is May and XYZ is trading at $33 when you decide to buy 1 XYZ JUN 30 CALL for $4. If XYZ went up, so would your option. For example, if XYZ increased from $33 to $38, your call would also increase from $4 to perhaps $9. In both cases the asset has increased by $5, but that is an increase of 125% in the option and only 15% in the stock.

Conversely, if XYZ went below $30, the option would be Out-of-the-Money and its value would decline toward zero as it neared expiration, costing you 100% of your investment.

When you see a bullish setup, the choice to buy call options just adds leverage. You have to make the choice.

• Buy 100 shares of stock @ $32 for $3,200 or buy one (1) contract of call options @ $3 for $300.
• If the stock goes up $2, the profit on the stock is 6% ($200/$3,200) or the profit on the call option is 30% ($100/$300).
• If the stock goes above the strike price, you can exercise the option (buy @$32 and sell @$37) or sell the option. However, if you exercise the option, you lose the option premium.
• If the stock is going down, you can buy the put option @ $3.

Buying Puts

If you are bearish on a stock, you might want to buy puts.
To illustrate put buying, imagine it is May and XYZ is trading at $33 when you buy 1 XYZ Jun 35 put for $3. As the price of XYZ declines, your put becomes more valuable. For example, if XYZ dropped from $33 to $30, your put would increase from $3 to around $6. In this case a 10% drop in the stock could cause a 100% increase in your put.
Conversely, if XYZ rallied and then stayed above the $35 strike price, your put would be Out-of-the-Money and decline in value as it neared expiration. Of course XYZ might also fluctuate wildly before expiration, giving you various opportunities to sell or exercise your put.

Puts As Insurance

Another important use for put options is insurance on stocks that you own. If you own a stock and you have a forecast that the stock may fall, you can purchase a put option to help as protection against the decline. If the stock does fall, then the option goes up in value and offsets the declining value of your stock.
This strategy is similar to someone that purchases fire insurance on his or her house. If the house burns down, then they get money to build another house. If it doesn't burn down, then they've paid for insurance that they didn't use. If you buy a put option on a stock and it doesn't fall, then you've essentially paid for insurance that you don't use.
Typically you would only use puts on a fundamentally sound stock that is still showing overall technical strength, but may have a short-term pull back. You could also buy some puts on a stock that has an impending announcement that is extremely uncertain, and you don't want to be left without protection, but you'd like to keep the stock in case the news is good. A company that is awaiting FDA approval on a new drug would be a good example of such a situation.
You are using put options as a form of insurance against downturns in the price of a stock, without losing the upside potential of stock ownership. Let's say that you own 100 shares of XYZ, purchased at $60 a share, a $6000 investment. XYZ has increased to $81 you have an unrealized gain of $2100; but you now have short-term concerns such as an earnings announcement or bearish sentiment in the markets.
You don't want to sell your stock and take the short-term capital gains and you think in the long term the stock will continue to rise. By purchasing 1 XYZ JUN 80 PUT for $4, you acquire the right to sell 100 shares of XYZ, the same number of shares that you own, for $80 anytime before expiration while keeping your stock. Here is the formula for how much protection you have bought.
Strike price of put $80; Stock purchase price $60; Premium $4; Protected profit $16 per share. You have protected $1600 of your $2100 gain!
If the stock moves up you will lose the $400 it cost you to buy the insurance, but you will have the gain in the stock to off-set the cost of the, in this case, insurance premium.
It the stock moves down, let's say to $50 for our example, you would still be able to sell your stock for 80 per share minus the 400 it cost for the put.

Let's do the math to see how it works.

Bought at	-$60
Sold at	+$80
Cost of put	-$4
Profit	$16 per share

You still would have made a profit of $16 per share on a stock that is down $10 from where you bought it.

Buying Options Summary

The purchase of options is typically a more aggressive strategy that many investors may never undertake. However, it can be quite exciting and financially rewarding if you are able to master the rules and strategies that have been presented.

The Guidelines of Buying Options

• Buy 2 to 4 months
• Buy In-the-Money
• Buy At-the-Money
• Look for options with tighter spreads
• Open interest above 50
• Make sure you are using precise money management guidelines and stops
• Pick an exit
• Use trailing stops if you don't want to exit the trade
• Otherwise 10%
• 50% safety net for unexpected disasters (Volatile Stocks)
• Move at least $1.00 either direction a day

An investor should proceed with caution when venturing into any new strategy and always practice and paper trade to prepare for the real markets and the real risks that exist when trading options. We do not recommend or encourage any particular strategy or course of action to any investor. We merely wish to expand your investing horizons and increase the choices you have as an investor.