Buying and Selling options

Many investors trade options to buy or sell common stocks (calls and puts) as a speculative way of investing. Options are traded on organized stock exchanges. They represent one of the more complex investment strategies because of the different ways to structure your options portfolio. While we don’t discuss everything about options here, we talk about put and call options so that you have a better understanding of what they are and how they work.

A call option allows the purchaser to buy from another investor a certain stock or other asset at a predetermined fixed price, the strike or exercise price, at any time during a specified period. A put option allows the purchaser to sell to another investor a certain stock or asset at a set price at any time during the specified period. Options, which are normally around lots (100 shares) of common stock, have standardized quarterly expiration dates. The expiration date is the last date on which the option can be exercised.

Buying Options

Investors can buy both call and put options when they think the underlying stock is going to go up or down. Rather than paying a price per share, as you would with regular common stock, the investor pays a premium for the option. The investor then has the opportunity to hold, exercise, or sell the option. If he or she chooses to hold the option without exercising it, it will expire worthless and the investor will have lost the amount of money that was paid for it. If the investor chooses to exercise the option, he or she will then either buy or sell the underlying stock at the set price, depending on whether it’s a call or put option. But, if the investor sells the option, he or she will either have a gain or a loss on the option. It will depend on whether the premium that the investor sold the option for was greater or less than the original premium. For example, if you purchased a call option for $300 and later sold it for $500, your gain would be $200, and vice versa.

Purchase call coptions for $300
Sell unexercised option for $500
Net gain (loss) $200

Selling Options

Investors sell, or write, options for the opposite reason that they would purchase them. Usually, the investor has a position in the underlying stock and is looking to make a profit. The increased profit stems from the premium earned by the option writer for selling the option. However, if the option is exercised, the option writer (and usually the stock owner) forfeits the opportunity to sell his or her shares of stock on the common market. Conversely, if the option sold was a put option, the option writer would then wind up paying a higher price for the stock than if it had been purchased on the stock market. The writer would still wind up profiting from selling the option because of the premium he or she would receive. Those that write options don’t necessarily have to have a position in the underlying stock. “Naked options” are those in which the writer doesn’t own the underlying stock. They are highly speculative because if the option is exercised, the writer is then forced to cover his or her position. For example, Mark Client writes (sells) a call option for 200 shares of XYZ stock. The strike price on the option is 65. The premium paid for the option is $400. XYZ is currently trading around $72 per share. Therefore, the new owner of the option has the opportunity to buy XYZ stock for $65 per share, rather than at around $72 per share on the open market. The option is exercised, and now Mr. Client has to sell the option owner the 200 shares of XYZ for $65 per share. However, Mr. Black sold a naked call and doesn’t own the 200 shares of XYZ. He then must buy the shares on the open market for the market price and then sell them for $65 per share. Let’s say he pays $71.50 per share for the stock. He, therefore, has a net loss of $900. Premium paid to Mr. Black for option $400

Purchase of stock paid to Mr. Black (200 shares @ $65 per share) $13,000
Purchase price of stock Mr. Black paid at market
(200 shares at $71.50 per share) $14,300
Net gain (loss) ($900)
$14,300 - 13,000 - $400 = $900

Options can be highly profitable for those who choose to invest in them. However, they carry a high amount of risk, as well. Investors may lose the entire amount committed to options in a relatively short period of time. For those whose risk tolerance can handle options, they are a good investment. Be sure, though, that if you decide to try some option trading you can handle the risk.You can obtain a current option disclosure document from your broker or from the Options Industry Council. You can call 1-800-OPTIONS or visit the Options Industry Council’s website: www.888options.com.