Trading Options Course | Put Options

In the next part of our trading options course we'll start talking about put options, the opposite of call options (which we discussed in an earlier post).

Put Options Represent the Right to SELL

First and foremost put options represent the right to SELL an asset. The asset can be any number of things ranging from stocks to currencies to indexes to interest rates.  How you as investor profit from trading put options depends entirely on how you choose to use them.

Principal Elements of Put Options

A put option is a contract with specifically defined terms. Almost invariably the contract will consist of a strike price (at which the asset will be sold), an expiration date (on or before which the contract must be executed), the number of shares per contract (nearly always 100), and of course the asset to be bought or sold.  The person who OWNS the option has the right to SELL the asset to the person who SOLD the option in the first place.  That probably sounds totally confusing, so let's talk about a real world example.

Buying a Put Option on Apple Stock

It just so happens Apple Inc. is in the news today given the health of Steve Jobs is failing.  If you know Apple's history and Steve Jobs... as goes Steve, so goes Apple... so one might surmise that today it might be a good day if you're already an owner of a put option on Apple stock.  So lets pretend we went to buy a put option on Apple stock last Friday (the last day markets were open).

At the close of trading on Friday a January 2011 put option with a strike price of $345.00 (near Apple's approximate closing price on Friday which was $348) would have cost $5.91 to buy in the market. Buying (going LONG the Put Option contract) would cost $591.00 ($5.91/share x 100 shares/contract).

Now consider that if we were to execute the contract Friday we wouldn't get any money!  Why would we want to sell shares at $345/share when we could go into the market and sell them for $348?  Doesn't make sense does it?  And yet according to the finance pages there are 14,000+ contracts open at this time.

Why People Buy Put Options - Trading Options Course Lesson in Market Timing

Over the holiday weekend Steve Jobs announced he is taking a leave of absence from the company.  Steve is and always has been the driving force behind the value creation of Apple Inc.  The last time he took a leave the stock immediately tanked, and here we are years later about to open the market again after a "Steve is leaving" announcement and the shares are down $15 to ~$323.00.  Approximately how much will the put options on Apple Inc. stock be worth on Tuesday when the market opens?

The answer is the value of the put options will be AT LEAST the amount of money you can make by simply executing the contract and selling the shares, ie the difference between the strike price ($345) and the current market price ($323).  The put option contracts should open this morning at least $12.00/share, making the Friday investment of $591 now worth at least $1200. Not a bad return (doubling your money) for one weekend's risk, eh? (editor's note: for the record the $345 January 2011 put option opened around $13.00)

Now does the decision to buy put options for with a price of $345 make sense? I hope trading put options makes a little more sense to you today.

Options Trading Tutorial | Call Options Explained

In the next post of the options trading tutorial series we'll talk about call options. A call option represents the right to buy a specific number of shares of a company or other asset at a specific price on (or before - in the case of Standard -or American- options) a specific date.

Call Options Explained

A call options trading tutorial has to talk about three critical pieces of information: the strike price, the expiration, and the call premium. Each of these bits of information play a critical role in determining the ultimate return on investment for the options trader.

Call Options: Explaining the Strike Price
The strike price of a call option is the price at which the option holder (long position, or buyer of the call option) has the option to pay for a set number of shares of stock (or some other asset) on or before a certain date. If the shares of stock (IBM for example) is trading ABOVE the strike price of the option, the option is considered "in the money." A call option buyer (or LONG) would be able to execute the option contract, forcing the counterparty to deliver the specified shares at the strike price. The option holder (now a share holder, given that the shares have been delivered) would have the freedom to re-sell the shares into the market at a higher price (see put and call option trading examples) and therefore cashing in the difference between the price paid (strike) and price sold for (market) as trading profits.

Call Options: The Expiration Date Explained
The expiration date on a call option (standard or American options) refers to the date on or before which an option must be exercised otherwise it expires (or can be subject to automatic options execution - not always a good thing for the trader short of cash). A call option which expires out of the money is worthless while an in the money option pays a profit (explained above - the difference between strike price and the market price of shares less the call premium times the number of shares in the contract). On *MOST* stock options contracts, the expiration is the third Friday of the month at the close of trading in New York (4pm EST). Sometimes there are options contracts which expire at the end of a quarter. It is extremely important to know when your options contracts expire, and to have your trades settled long before then unless you intend to exercise the contracts (a rarity these days because of the huge cash commitment involved... and the fees).

Explaining the Call Premium
The call premium on a call option contract is the fee the buyer of the contract pays to the seller of the contract (through a clearing house - to be explained elsewhere later). The call premium is essentially the market price of the contract - meaning the "fair" price the market has established for the contract based on a number of factors, including the probability of in the money expiration, the risk free rate, the volatility of the market, the number of days before expiration, and the current price of the underlying stock or asset.

In this options trading tutorial on call options we explained call options premiums, expiration dates, and strike prices. Options trading is risky and can result in significant losses of capital.