Section: 3
Till now we have covered the very basics of option trading in Section 1- Basics of options and also one type of option contract as call option under Section 2 – Type of options.Before we go to the topic of ‘Put options’ there is one more concept to familiarize and this related to the expiration of the option contracts.
Styles/Family/Class of option contracts
There are two different styles or class of options contracts, named after the two regions where they are most often traded. They are European style and US (American) style options, and this difference in style makes an important difference to the way in which they are traded. Simply the variation is related with the expiration of options.
As explained earlier in Section 1 also, the expiration date is the date after which the option contract ceases to exist. If an option is not exercised prior to the expiration date, the right contained in the option ceases to exist.
European style options can only be exercised on the expiration date, whereas US style options can be exercised at any time up to and including the expiration date.
Only the exercising (Actual delivery obligation is exercised by buyer or seller) of the option is affected, so both European and US style options can be bought and sold at any time.
So this leads to answer the following abbreviations
What are CE and CA?
CE denotes European Call option and CA denote American Call option, this way PE denotes European Put and PA is American Put.
Put Options
The topic of put option is divided into two concepts below as buying put and selling put.
Buying put option:
Put options give the buyer the right, but not the obligation, to sell an underlying asset/stock at the strike price until the expiration date.
One of the reasons to enter put option is that if there is the expectation of the market prices to fall (also called bearish outlook). Other major factor that put option provide is the Protection to the script holder, let’s say if the particular scrip holder has been in profits from the script he/she holds and he want to keep it for some more time but the present outlook shows the weak market conditions, here buying the put give the option to sell the script at the predetermined price till expiration if the markets falls, but if the markets improves contrary to predictions this also help the script holder to continue enjoy the more profits but with the little cost paid as premium to buy the put as to secure his/her trade.
Now let’s discuss the put option in action with the example below:
We consider the case of Sam who is little worried about the 100 shares of IMC stock that he owns. The stock has risen from $40 to $85 in the year time he was holding, and a “two to three month pull back to $70” is predicted by a market experts or analysts. Sam is worried that, if the expert’s forecast is correct, then he will lose $15 of his gains. However he is also worried that, if he sells the stock and the experts go wrong, then he will miss out on a continued price rise.
Assuming that today is August 20 and that the IMC October 85 Put is trading for 3.50, then, instead of simply selling his IMC stock, Sam chosen an “insurance alternative” by buying put option. If Sam purchases the October 85 put for $3.50 per share, or $350 not including commissions, then he will have the right, but not the obligation, to sell 100 shares of IMC stock at $85 per share at any time until the October expiration date. The maximum risk of purchasing the put is the price of $350 plus commissions, but, as we will see, purchasing the put reduces the risk of owning the IMC stock.
If the stock price rises above $85 at the October expiration date as Sam hopes, then he will let his put expire. He simply will not exercise his right to sell IMC stock at $85 per share, and he will lose the $350 plus commissions that he paid.
However, if the price falls to $70 as the analyst prediction, or any price below $85, then Sam can do one of two things. Either he can exercise his put, or he can sell the put. If Sam exercises the put, then he will sell the stock at $85 per share and receive $8,500 less commissions. He will also have paid $350 for the put option, which he has to loose.
If Sam chooses to sell the put rather than exercise it, then he will receive cash for selling the put and still own the stock. If IMC stock is trading at $70, then the 85 Put is likely to be trading at or above $15 per share, or $1,500. The put option price of $15 per share is simply calculated as follows: with a stock price of $70 per share, the right to sell at $85 per share is worth at least $15 per share. If Sam purchases the IMC 85 Put for 3.50 and sells it at 15, then he will earn a profit of 11.50, or $1,150, not including commissions. Such a profit on this put option will largely offset the price decline of $15 per share from $85 to $70 in his IMC stock. And Sam will still own the stock with all the profit potential - and risk - that stock ownership exists as before.
The example above clearly shows the potential advantages that a put option can provide but that also cost some money as premium paid to acquire the put option.
Take a quick look to the benefits that a strategic put option has provided in our example. First, purchasing the put enabled the holder to continue owning his IMC stock, which enabled him to profit in case the price rose, and second, it limited the risk of owning that stock at the same time.
Other reason the put option have been purchased is speculation as an alternative to going short with actual stocks (Selling stocks in advance to buy it later on lower price), because going short with actual stocks have a very high element of risk and may lead to huge losses if stocks move upwards in contrary to speculators predictions and the put option limits the risk to the amount of premium paid.
Selling put option:
The very first thing to mention here is, a put seller has the obligation to buy the underlying stock (usually 100 shares per option) at the put strike price by paying the full amount not only the margin. In other words, the option seller must be ready to have the stock "put" to him or her.
That’s why selling put option is less common in the individual level trading. The put seller/trader believes the market will rise and sells puts. The put seller's risk is the drop in the stock price. The put seller profit equals the credit received from the sale of the put. Put sellers often prefer options with little time left until expiration because they want a put to expire worthless. In that way, the seller keeps the entire premium he/she received while selling.
Now with this we can conclude the topic of ‘Basics of Options’. Please remember that much more study and well-planned strategy is vital to trade in options. Here we just mention the basics of option concepts and you should not in any way yet ready to trade with options with this much knowledge only. Also keep reading the updates under option category/label.
