Section 2
Going forward, you will see that options give the choices/options to investors or traders to match their specific plan to a specific strategy thus adding value to current trading.
But firstly let’s get started with the types of options. There are two types of options - Call and Put.
Let’s begin familiarizing with one more common term. :Call option gives the buyer the right, but not the obligation, to buy underlying instrument/stocks at the strike price/predetermined price until the expiration date.
Market Lot: In options the buying and selling is in lots, let’s say lot of 100 (One contract = the option to buy 100 shares of stock XYZ). That means that if you see the price of the option at $1, it will cost you $100 for one contract. Different stocks have different lot’s sizes.
In order to obtain this right to buy, the buyer must pay a price, mentioned as premium.
Buyers of calls buy in hope that the stock will increase substantially before the option expiry date.
The writer/seller, of a call option is obligated to deliver the 100 shares upon notification from the buyer. In return for assuming this obligation, the seller receives the premium.
This premium goes to the person that sold you the option. This is their reward for the risk they take in selling you the option. The longer an option is from its expiration date, the more premium you will pay.Now that you know the basics of call options, here is an example of how they work.
Till now you must know about two type of participants in option markets
1. Buyers of calls
2. Seller of calls
Let's say that on August 1, the stock call option of IM Co. with strike price of $80 is at the premium (cost) of $3, with expiration date on the last Friday of this month. So in short we can mention it as $80 August ending call. The market lot we assume here is 100 shares. So the total price of the buy contract is $3 x 100 = $300. In reality, you'd also have to take commissions into account, but we'll ignore them for this example. The purchaser of this call pays $3 per share and obtains the right, but not the obligation, to buy 100 shares of IM Co stock at a price of $80 per share at any time until the last Friday of August. The writer, or seller, of this call receives $3 per share and assumes the obligation of delivering 100 shares if the owner exercises the right to buy.
If, the price rises to $90, then buyer can exercise his/her call and purchase 100 shares of IM Co stock at $80per share, or $8000 plus commissions. At that point buyer will own the 100 shares, if buyer had planned to sell the stock when it reached $90 per share, then he/she can sell it. If buyer planned to hold the stock in his/her portfolio for the long term, then he/she can continue to hold it.
In other case, if the stock price declines to $70 at the expiration date, then buyer will let his/her call expire. Buyer simply will not exercise his/her right to purchase the stock at $80 per share, and will lose the $300 plus commissions that he/she paid.
In this example, the IM Co August 80 Call gave the buyer two advantages over the straightforward purchase of the stock. First, the call limited the risk to $3 per share, if the price falls the buyer simply let his/her call to expire and, second, buyer locked in a known purchase price and if share price increases as per buyer expectation it will give handsome profits, because anything above $83 (buying price of 80 plus premium paid of $3, this comes out $80 + $3 + $83) will equals to profits.
In next article we will discuss put option, please make yourself sure to understand the concepts till here, this is important to go any further otherwise you won’t able to understand what is coming next, so just go through the article again if you have any doubts in your mind.
