Foundations of Trading: Options [Part 9]
Last week’s blog covered the concept of Time Decay and how it affects your options trades. If you wish to review that blog or any other blogs in this series, please click on the Foundations of Trading blog category on the right-hand side of the page, which will instantly bring up all the blogs from our program for your review. As for today’s blog, we will close out this blog series with coverage of class 7, which examines placing long calls and short puts option trades.
Long Call Review
A call option gives the buyer the right but not the obligation to buy shares of the underlying security for a certain price by a certain date. The monetary value of a call option increases as the value of the underlying stock increases, which means call options are bullish in nature. These options are valuable to short-sellers as they function as a type of price insurance.
Let’s say you’re bullish on Micron Technology or MU. By buying an 80-strike call option, you reserve the right to buy MU for $80 a share. If MU goes to $84 or even higher, you still have the right to purchase shares for $80. Thus, the higher MU goes, the more valuable the right to buy at $80 becomes. Just like a stock, our call option can go up in value forever. When you buy an option, you can only lose what you paid for that option, and in this case, that is $2.54 a share. This means that the most you could lose on this stock is $2.54 a share, no matter what the stock does.
A few points to remember as the options buyer, you have bought a contract, you have the right to the stock in question, and you have paid money. On the flip side, the options seller has sold a contract, has obligations to provide the stock in question, and has received the money. And the final point to always keep in mind, the major downside of buying a call option is that the stock needs to move more than you paid for the option to be profitable.
Short Put Review
As a reminder, a put option gives the buyer the right but not the obligation to sell shares of an underlying security for a certain price by a certain date. The monetary value of a put option increases as the value of the stock decreases, which means put options are bearish in nature. These options are valuable to long buyers as they function as a type of price insurance.
By selling a put option, you obligate yourself to buy 100 shares of the stock in question at the strike price. In return, you receive the value of the put option upfront. Remember that anytime you sell something, you bring in cash. This premium that you receive is your maximum profit on the trade. Your risk on the trade is that you have to buy the stock. By selling put options, we are essentially acting as the insurance company. Someone pays us a premium to protect their stock positions. If the stock goes down, we may have to buy the stock from them.
For that reason, there are two main rules for selling puts. First, you should only sell puts on a stock you want to own, and secondly, you must make sure you can afford to purchase 100 shares of the stock for every contract you sell. After all, we are promising to buy the stock if it goes below the strike price, but as long as the stock stays above the stock price, the option expires worthless, and we keep the premium.
Here are a few points to always keep in mind when selling short puts. This is a great strategy to create income from a stock you don’t even own and is often used to buy a stock at a more favorable price. You should always sell the strike price at which you’re willing to buy the underlying stock. You should sell put(s) that expire in 30 days or less and ideally sell weekly puts if available. Remember that you need Strike Price x 100 in cash to trade this strategy, as your obligation to buy the underlying stock is secured by the cash in your account. Finally, always sell Out Of The Money (OTM) puts as there is a better stock price and more chance for the option to expire worthless.
In Closing
Thank you for reading the full coverage of Chris’ option classes. And if you have any questions regarding the contents of this blog, please stop by to see our teachers and moderators in our Group Coaching sessions which happen every Thursday, and have Chris dive a little deeper into his example as there was way more in each class than what we covered in this blog series. For access, please contact Rebekah at info@tradesmartu.com for details on Group Coaching sessions. Thank you for reading, and we look forward to seeing you next week!
