Calls And Puts
Blog 2: Calls And Puts
Sam Hooker
To start, it is important to know that an options contract grants you the right, but not the
obligation to buy or sell an underlying asset at a set price on or before a certain date. The two most
common uses of options are to buy a call or put option. A call option gives the holder the right, but not the obligation to buy a stock at an agreed upon price if it is before an agreed upon date. For example, lets say I am an investor and right now stock XYZ is at $100, but I think in the next month it will go up to $150. I can purchase a stock option right now for the right to buy stock XYZ anytime in the next month for $100. In order to purchase this option I will have to pay a premium to the issuer. For this example lets say the premium is $10. If in two weeks the stock price is $125, I can exercise the option and trade the issuer $100 for his stock of XYZ currently valued at $125. In this example the profit I would have made is $125 – $100 – $10 = $15.
Now, lets say that the stock went to $90 instead of $125. Unfortunately, if you purchase a call
option on a stock and the price of the underlying asset goes down, you will lose money. Again, the
maximum amount you can lose is the premium paid, so the investor would only lose $10. In order to break even on this trade, the price of the stock would have to go to at least $100(par) + $10(premium) = $110. A put option gives the holder the right but not the obligation to sell the stock at an agreed upon price before an agreed upon date. Purchasing a put option operates almost as an insurance policy to the holder. For example, if I am an investor and I think stock XYZ, which is currently trading at $100, will drop in the next month, then I can purchase a put. Lets say the premium or cost to purchasing this put is $10 and in two weeks the price of the stock is at $75. I have the choice of executing my option and trading the issuer my stock of company XYZ for $100. Vice versa if the price of the stock goes up, I will choose not to exercise the option and I will lose the premium paid.
To summarize, one of the reasons why options are attractive is because of the much higher ROI
compared to just purchasing a stock. For example if I buy stock XYZ for $100 and in 2 weeks it is at $150, than I made $50, a ROI of 50%. However, if I purchased a stock option at $100 for $10 and the price rose to $150 than I would have made ($150-$100-$10) $40, a ROI of 400%. This is why investing with options is an effective strategy to add leverage. Instead of risking the $100 to buy the stock, which could have gone to zero, this investor only risked $10.