Buying an options contract is basically entering into an agreement with the seller to buy an option to purchase a security at a predetermined price (strike price).
To buy this option you have to pay the seller a fee, known as the options premium. For this premium the options seller (writer) agrees to sell you the shares at the predetermined price upon expiry of the option.
It’s important to realize that you’re under no obligation to buy the stock; you can simply pass if you want to, if you do that you’ll only have to cover the cost of the options premium. Sometimes this can be beneficial if the price of the underlying asset has moved against you.
A single equity options contract consists of 100 shares of the underlying stock. So if you buy one July 50 Call in Apple and you exercise the option at the end of July. You would be buying 100 shares of Apple at $50 each and would therefore need $5000 to cover the cost of the trade. Alternatively you could let the option expire, or more likely sell it back to the market.
Puts and Calls
Essentially there are two different types of options, puts and calls. A put buyer expects the price to fall and a call buyer expects the price to rise.
This can be confusing to anybody new to options because you can also sell puts and calls. To make it simple look at it this way, for every buyer of a put there’s a seller of a put and for every buyer of a call there’s a seller of a call. In this article we’re going to concentrate on the buyer. You can read more about selling options here.
Buying a Put
As I said if you’re buying a put, you’re essentially expecting the underlying stock to fall in value. Let’s take a look at an example.
Let’s assume that PepsiCo (PEP) is currently trading at $44. You expect that the price will fall dramatically in the short term, due to a recent price war with Coca-Cola. So you decide to buy a Jan 40 Put, which costs you $100.
This means that the price of PEP needs to drop to $40 before the end of January for you to make a profit.
Sure enough at the end of January, PEP is trading at $40 so you can exercise your option to buy the stock at $40 ($4000) and immediately sell it back to the put writer (seller) for $44 ($4400) making a profit of $300 after you’ve covered the price of the option premium.
In the real world most options are sold long before the expiry date. That way you won’t have to find the capital needed to buy the underlying stock.
Buying a Call
Now let’s look at buying a call option, this is essentially the same as buying a put except this time you expect the price of the underlying stock to rise.
Let’s look at our PepsiCo example again. The price of PepsiCo (PEP) is currently trading at $44. But this time we expect the price to rise due to an uncommonly hot summer, so you buy a JUL $47 Call, which costs you $100.
This means that the price of PEP has to rise to $47 for you to make a profit. Sure enough at the end of July the price is trading at $47. You can now choose to exercise your option and buy the stock at $44 ($4400) then immediately sell it back to the market for $47 ($4700) leaving you with a profit of $200 after covering the price of the option.
Again, there’s no need to wait until expiry to sell the option. You can sell the option at any time regardless of whether you’re in the money or not.
It’s important to note that the above examples do not include broker commissions. When you place a trade you’ll have to pay your broker a small commission to execute the trade. These commissions vary form broker to broker but are usually around $10 or $20.
When you get a little more experience you might want to consider using a broker that specializes in frequent trading. A good example would be OptionsHouse who charge as little as $0.15 per contract (+$8.95 per trade).
You can see that buying options can be very lucrative; in fact you’re much better off trading options than trading the actual underlying stock because you’ll get a much higher risk reward ratio.
If you’re new to options you need to choose your broker carefully, don’t be tempted to use the cheapest broker you can find. Trading options can be daunting at first so you’re far better off looking for a broker with excellent training materials and seminars. Our favorite broker for beginners is optionsXpress, here you’ll find some excellent training materials to help you on your way. You can always move onto a more specialized broker later if needs be.