Options are perhaps best thought of as the name implies, as a tool which gives their owner options. Since the market has both buying and selling activities, we also have options associated with each transaction:
Let's look at a couple of basic examples to bring some clarity to the issue.
Example 1: If you have a $100 call option on stock XYZ, you have the right to purchase shares of XYZ for $100. This could be a great deal if stock XYZ were currently trading at $125.
Example 2: If you have a $200 put option on stock ABC, you have the right to sell shares of ABC for $200. This could be a great deal if ABC were currently trading at $150.
In both of those examples, you have the option to either buy or sell shares at a certain price. With that context, the formal definition of an option should make a little more sense.
The purchaser of a call option has the right, but not the obligation, to buy a stock at a certain price, on or before a specific date.
The purchaser of a put option has the right, but not the obligation, to sell a stock at a certain price, on or before a specific date.
Notice there are four components to an option as defined above:
With this basic definition in mind, here is an example of how we might use options as a trader.
An analysis of the AMZN chart above would likely yield the following conclusions:
This would be a bullish trade to consider taking. But what if you did not have $707 per share you were willing to risk? In that case, you can choose to buy a Call Option instead. What if we purchased a $705 Call option that was good until October? That means anytime between now and October; we could buy our AMZN shares at $705, which is nearly $3 less than it is currently trading.
The total cost of the $705 October Call option is going to run us roughly: $41 per share.
Here is how the trade played out. Fast forward to current events, August 8th, as of this writing. AMZN is now trading at $766.56. And the great part is we have the right to buy it at $705 which is a savings of $61.56 off from the current trading price.
One way we could use our option now is to purchase shares at $705 and then immediately sell them for $766.56, giving us $61.56 in profit. Not bad, considering we only paid $41 for the option. If you consider the cash we spent on the option, we have an actual profit of $20.56.
There is a second way we could have exited this trade. What if instead of buying and then selling the stock, we instead sell the actual option contract we own. Remember, we paid roughly $41 for the October, $705 Call. Today, as I write this, that same call is now worth much more. Look at the screenshot below and see if you can identify the four parts of the option:
Investors tend to look at options as a tool for hedging their positions. Consider the put option. Remember, when you own a put option, you have the right but not the obligation to sell shares at a certain price on or before a certain date. Let’s take a look at LUV, which just had earnings a few weeks ago. Heading into earnings, we did not want to liquidate our position because we were still three weeks away from the magic 1-year requirement to avoid taxation at the regular earned income rate. However, we also had a hunch LUV might take a hit because of their recent technology defect that caused thousands of flights to be canceled.
Faced with the prospect of either selling our shares and taking a tax hit or holding on a loss over earnings, what if we instead decided to buy a put option? In this case, we could choose to buy a $42 put option the day before earnings were reported. The cost of our $42 put option would be roughly: $2.70 per share. That's a pretty cheap insurance policy to be sure your investment does not tank during a volatile earnings event.
Here is how this trade played out. The day following the earnings report, LUV dropped nearly 11% to 37.45 and ultimately hit a low of 35.43.
There is no need to worry, as we have a put option which allows us to liquidate our LUV shares at $42 if we desire. A keen eye, however, might notice that LUV just formed a new support zone. Perhaps the fear of LUV crashing has subsided a bit in our mind. If so, we might now consider selling our Put option. Look at the option chain below and see if you can figure out how much we might sell the $42 September Put for today.
If you said that you could sell your puts for $4.50 today, you are right. The same puts you paid $2.70 are now worth $4.50. That's $167% ROI on your insurance policy and, you also avoided the taxation issue as well as hedged your risk during the earnings event.