A common question we get is:
How Do Options Work?
It’s a good question.
If you google “How do options work?” you’ll be inundated with definitions that essentially say:
Options are contracts between two people — a buyer and a seller. Call options represent a right to buy 100 shares of stock at a certain price. Put options represent a right to sell 100 shares of stock at a certain price.
But that definition raises the question: Do I have to?
For instance, when buying call options, what if you don’t want to buy the shares? Or, what if I don’t have enough cash to buy 100 shares of the stock? And for puts, what if you don’t even have the shares to sell? Will you just lose your money on these options?
To answer those questions, let’s look at an example.
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How Do Call Options Work?
You purchase a $100 strike call for $2.50 — which remember, really means $250 dollars total! That means $2.50 is your maximum loss, which would occur if the stock price closes at the $100 strike or below at expiration. Remember, call options are a bet that the stock price will rise.
Now, let’s say that the stock rises to $105 dollars at some point in the options life. That $100 strike call is now giving you an advantageous purchase price!
How big is the advantage? $5.00.
That’s because you could exercise the call, pay $100 for the shares, and immediately turn around to sell them for the current $105 dollar market price. Because of this, the $100 call must be worth at least the $5 dollar difference. If time still remains on the option, it would be worth even more than $5 dollars. However, if you’re right at expiration, this call would trade exactly at $5 dollars.
So, let’s recap. You spent $2.50 to buy your call. The stock rose to $105, and you sold your call option for $5.00. That means you scored a 100% gain on your initial trade, even though the stock price only rose 5%. That’s the option leverage at work. You captured the full $5 gain in the stock, but only paid $2.50 to control 100 shares, rather than paying $100 for the stock.
See, it isn’t so hard!
Let’s test your knowledge with a quick pop quiz.
What would that same option be worth if the stock rose to $110 dollars?
That $100 call now conveys an immediate $10 benefit. So the market ensures that the $100 call must be now worth at least the $10 dollar difference. At expiration, this call will be trading for exactly $10 dollars. You could choose to sell right here. If you do, you paid $2.50, but sold for $10.00. That means your investment increased four-fold — or 300% — even though the stock price only rose 10%.
Notice that call options become more valuable as the underlying stock rises. So there’s no need to ever buy the shares of stock. Instead, the market price of your call will rise and fall with the market price of the stock. So instead of having to buy 100 shares, you can always just sell your call on the open market, and profit from the difference between the purchase price and the selling price.
Now it’s important for new traders to understand that your options, whether they’re calls or puts, won’t necessarily rise or fall, dollar for dollar, with the stock. In some cases they will, in other cases they won’t. But they will track the stock’s performance to some degree. That said — that’s a topic for another video!
So now that we’ve covered how to make money with call options without buying the shares of stock, let’s take a look at how you could make money with put options without owning the shares. Making money with put options is similar, just in the opposite direction!
How Do Put Options Work?
Let’s say that you bought a $100 strike put for $2.50, or $250 dollars total. Remember, put options are the opposite of call options — they’re a bet that the stock price will fall. Now assume that the stock price falls to $95 dollars. Because you own the $100 strike put, you have the right to sell shares for $100 dollars. That’s a better selling price than the current $95 dollar market price.
How much better? $5 dollars better.
So this option is conveying a $5 dollar benefit — that means it must trade for at least $5 dollar on the open market. If there’s time remaining, it’ll trade for more than $5. But it’s gotta be worth at least $5 dollars.
At expiration, if the stock is still trading at $95, the option will be worth exactly $5.00. If you sell your put for $5 dollars, and you paid $2.50, then you have doubled your money and earned a 100% profit.
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However, what if the stock had instead fallen to $90? You already know what’s next: The $100 strike put must be worth at least the $10 dollar difference. So, you could sell your $100 strike put for the $10 dollar market price, and because you paid $2.50, you raked in a four-fold increase — or a 300% return on your money — even though the stock price only fell 10%.
So, let’s answer the question from above: Does buying options mean you’re making a commitment to buy shares?
No! Long Options Do Not Require the Purchase of Any Shares!
If you’ve ever wondered how to make money in the markets by trading options, the answer is that they can be bought and sold on the open market with no need to ever buy or sell shares of stock.
If you have any questions about this video, or would like to learn how options can help you meet your financial goals, read on! Market Rebellion’s Rebel Hub has a wealth of free options trading information for you to enjoy.
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