Buying Options

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Buying a Put Option

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A person would buy a put option if he or she expected the price of the underlying futures contract to move lower. A put option gives the buyer the right, but not the obligation, to sell the underlying futures contract at an agreed-upon price—called the strike price—any time before the contract expires.   Because buying a put gives the right to sell the contract, the buyer is taking a short position in the futures contract.   The person selling the put option would be taking a long position. 

Options are considered to be derivatives of futures because they derive their value from the value of the futures contract they’re associated with. Calls are the other type of option. They give the buyer the right to purchase the underlying futures contract before the expiration date.

Futures contracts—and, consequently, options—can be based on a variety of assets or financial markers, including interest rates, stock indexes, currencies, and energy, agricultural, and metal commodities. 

A put option is said to be in the money when the market price of its underlying futures contract is lower than the strike price because the put owner has the right to sell the contract for more than it’s currently worth.   A put option is out of the money when the market price of its underlying futures contract is higher than the strike price because the put owner could only sell the contract for less than it’s currently worth.

Finding the Right Put Option to Buy

Consider the following things when determining which put option to buy:

  • Duration of time you plan on being in the trade.
  • Amount you can allocate toward buying the option.
  • Length of move you expect from the market.

Most futures exchanges have a wide range of options in different expiration months and different strike prices that enable you pick an option that meets your objectives. 

Duration of Time

If you are expecting a commodity to complete its move lower within two weeks, you will want to buy a commodity with at least two weeks of time remaining on it. Typically, you don’t want to buy an option with six to nine months remaining if you plan on being in the trade for only a couple weeks because the option will be more expensive.

One thing to be aware of is that the time premium of options—their value based on how much time they have left before expiration—decays more rapidly in the last 30 days. Therefore, you could be right on a trade, but the option could lose too much time value and you would end up with a loss regardless. Therefore, you should always buy an option with 30 more days until expiration than you expect to be in the trade.

Amount You Can Afford

Depending on your account size and risk tolerance, some options may be too expensive for you to buy. In-the-money put options will be more expensive than out-of-the-money options. And the more time that remains before the expiration date, the more the options will cost.

Unlike with futures contracts, there is no margin when you buy futures options; you have to pay the whole option premium upfront. Therefore, options on volatile markets like crude oil futures can cost several thousand dollars. That may not be suitable for all options traders. And you don’t want to make the mistake of buying deep out-of-the-money options just because they are in your price range. Most deep out-of-the-money options will expire as worthless, and they are considered long shots.

To maximize your leverage and control your risk, you should have an idea of what type of move you expect from the commodity or futures market.

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The more conservative approach is usually to buy in-the-money options. A more aggressive approach is to buy multiple contracts of out-of-the-money options. Your returns will increase with multiple contracts of out-of-the-money options if the market makes a large move lower. It is also riskier, as you have a greater chance of losing the entire option premium if the market doesn’t move.

Put Options vs. a Futures Contract

Your losses on buying a put option are limited to the premium you paid for the option plus commissions and any fees. With a futures contract, you have virtually unlimited loss potential.

Put options also do not move in value as quickly as futures contracts unless they are deep in the money. That lower volatility allows a commodity trader to ride out many of the ups and downs in the markets that might force a trader to close a futures contract to limit risk.

One of the major drawbacks to buying options is the fact that options lose time value every day. Options are a wasting asset—they’re theoretically worth less each day that passes. You not only have to be correct on the direction of the market but also on the timing of the move.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

How to buy call options

Options are powerful tools that can be used by investors in different ways, and there is a relatively simple options strategy that can benefit buy-and-hold stock investors. This strategy allows them to maintain their opinion that a stock’s price is going higher—and profit from an anticipated increase—but limits their risk to the downside in the event they’re wrong.

This options strategy is referred to as the stock replacement call.

How it works

1. You find a stock (or ETF) you would like to buy.

2. Instead of buying shares of the stock, you buy a call option, giving you the right to buy the stock at a lower or equal price for a certain period of time.

By purchasing a call instead of shares, you are taking advantage of leverage; allowing you to use less money to gain positive exposure to the stock’s price rather than using more money to purchase the stock directly.

Let’s take a look at the possible outcomes from this strategy. If the stock price declines, you lose the premium you paid for buying the call. However, this is a hedged strategy, so your losses are limited to only what you paid for the call versus the potentially larger losses equaling the total decline in the stock had you just bought the stock outright.

If the stock price remains even, you lose some (or all) of the premium you paid for the call. Then you can decide to sell the call for a loss, or exercise your right to buy the stock.

However, if the stock price goes higher, you profit from the increase. Then you have to decide whether you want to exercise your right to buy the stock at the lower price or just sell the call and collect your profit.

Example trade

Let’s assume stock XYZ is currently trading for $145 per share. You would like to buy 200 shares of stock XYZ. You could buy 200 shares for $145/share and have $29,000 of risk in the market. Or, you could buy 2 XYZ 135 calls for $12.50 and have a position very similar economically to owning the stock itself but do so with only $2,500 (2 X $12.50 X 100 = $2,500).

Using a standard profit-and-loss graph, you can see how stock replacement calls allow you to speculate that the price of a stock is going to rise, but also allow you to hedge if the price of the stock were to decline.

One question many traders may ask is, “How does someone choose what strike price to buy?” To help traders decide, there is a mathematical tool available to you called delta.

What is delta?

There are three definitions of delta, which are all true.

  1. It is the expected change in the value of an option’s price for a $1 move higher in the stock price
  2. It is the approximate probability that at expiration the stock’s price will be higher than the option’s strike price
  3. It is the price risk percentage of stock ownership that is currently represented in the option.

These definitions however are only as good as the models upon which they are based and outcomes are subject to changes in market conditions and volatility.В В

The third definition, in particular, is oftentimes a useful indicator to help determine which calls to buy. You can use the option’s delta to determine what percentage of price risk you want to take versus buying the stock outright. If you buy a 70 delta call, you have 70% of the price risk versus owning the stock outright. If you want a greater amount of price risk you can use a higher delta call; if you want less risk you can use a lower delta call.

Too often new option traders buy out-of-the-money options because they cost less, they think they’re getting a better deal, and they can buy more calls at a cheaper price. However, while the premium may be relatively inexpensive, remember that their probability of expiring in-the-money is very low (according to the second definition of delta above), which also means that the probability for a successful trade is also low.

Once you have decided which calls to buy, and have purchased them, you do need to monitor your position. It is important to note that you do not need to wait until expiration to see what happens; you can always unwind, or close, your options position before expiration. Just because there’s an expiration date attached to the options trade, it does not mean you have to hold it until that date. If the trade is profitable and you want to take your profits earlier than expiration, then do so! Conversely, if you experience losses on the trade and you want to limit further losses, you can just close the trade.

The stock replacement call is a way to maintain positive exposure to an increase in a stock’s price while limiting your risk in the markets, and utilizing less cash to do so. Open an account to start trading options or upgrade your account to take advantage of more advanced options trading strategies.

Call Option

What is a Call Option?

A call option, commonly referred to as a “call,” is a form of a derivatives contract that gives the call option buyer the right, but not the obligation, to buy a stock Stock What is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms “stock”, “shares”, and “equity” are used interchangeably. or other financial instrument Financial Assets Financial assets refer to assets that arise from contractual agreements on future cash flows or from owning equity instruments of another entity. A key at a specific price – the strike price of the option – within a specified time frame. The seller of the option is obligated to sell the security to the buyer if the latter decides to exercise their option to make a purchase. The buyer of the option can exercise the option at any time prior to a specified expiration date. The expiration date may be three months, six months, or even one year in the future. The seller receives the purchase price for the option, which is based on how close the option strike price is to the price of the underlying security at the time the option is purchased and on how long a period of time remains till the option’s expiration date. In other words, the price of the option is based on how likely, or unlikely, it is that the option buyer will have a chance to profitably exercise the option prior to expiration. Usually, options are sold in lots of 100 shares.

The buyer of a call option seeks to make a profit if and when the price of the underlying asset increases to a price higher than the option strike price. On the other hand, the seller of the call option hopes that the price of the asset will decline, or at least never rise as high as the option strike/exercise price before it expires, in which case the money received for selling the option will be pure profit. If the price of the underlying security does not increase beyond the strike price prior to expiration, then it will not be profitable for the option buyer to exercise the option, and the option will expire worthless, “out of the money”. The buyer will suffer a loss equal to the price paid for the call option. Alternatively, if the price of the underlying security rises above the option strike price, the buyer can profitably exercise the option.

For example, assume you bought an option on 100 shares of a stock, with an option strike price of $30. Before your option expires, the price of the stock rises from $28 to $40. Then you could exercise your right to buy 100 shares of the stock at $30, immediately giving you a $10 per share profit. Your net profit would be 100 shares, times $10 a share, minus whatever purchase price you paid for the option. In this example, if you had paid $200 for the call option, then your net profit would be $800 (100 shares x $10 per share – $200 = $800).

Buying call options enables investors to invest a small amount of capital to potentially profit from a price rise in the underlying security, or to hedge away from positional risks Risk and Return In investing, risk and return are highly correlated. Increased potential returns on investment usually go hand-in-hand with increased risk. Different types of risks include project-specific risk, industry-specific risk, competitive risk, international risk, and market risk. . Small investors use options to try to turn small amounts of money into big profits, while corporate and institutional investors use options to increase their marginal revenues Marginal Revenue Marginal Revenue is the revenue that is gained from the sale of an additional unit. It is the revenue that a company can generate for each additional unit sold; there is a marginal cost attached to it, which has to be accounted for. and hedge their stock portfolios.

How Do Call Options Work?

Since call options are derivative instruments, their prices are derived from the price of an underlying security, such as a stock. For example, if a buyer purchases the call option of ABC at a strike price of $100 and with an expiration date of December 31, they will have the right to buy 100 shares of the company any time before or on December 31. The buyer can also sell the options contract to another option buyer at any time before the expiration date, at the prevailing market price of the contract. If the price of the underlying security remains relatively unchanged or declines, then the value of the option will decline as it nears its expiration date.

Investors use call options for the following purposes:

1. Speculation

Call options allow their holders to potentially gain profits from a price rise in an underlying stock while paying only a fraction of the cost of buying actual stock shares. They are a leveraged investment that offers potentially unlimited profits and limited losses (the price paid for the option). Due to the high degree of leverage, call options are considered high-risk investments.

2. Hedging

Investment banks and other institutions use call options as hedging instruments. Just like insurance, hedging with an option opposite your position helps to limit the amount of losses on the underlying instrument should an unforeseen event occur. Call options can be bought and used to hedge short stock portfolios, or sold to hedge against a pullback in long stock portfolios.

Buying a Call Option

The buyer of a call option is referred to as a holder. The holder purchases a call option with the hope that the price will rise beyond the strike price and before the expiration date. The profit earned equals the sale proceeds, minus strike price, premium and any transactional fees associated with the sale. If the price does not increase beyond the strike price, the buyer will not exercise the option. The buyer will suffer a loss equal to the premium of the call option. For example, suppose ABC Company’s stock is selling at $40 and a call option contract with a strike price of $40 and an expiry of one month is priced at $2. The buyer is optimistic that the stock price will rise and pays $200 for one ABC call option with a strike price of $40. If the stock of ABC increases from $40 to $50, the buyer will receive a gross profit of $1000 and a net profit of $800.

Selling a Call Option

Call option sellers, also known as writers, sell call options with the hope that they become worthless at the expiry date. They make money by pocketing the premiums (price) paid to them. Their profit will be reduced, or may even result in a net loss, if the option buyer exercises their option profitably when the underlying security price rises above the option strike price. Call options are sold in the following two ways:

1. Covered Call Option

A call option is covered if the seller of the call option actually owns the underlying stock. Selling the call options on these underlying stocks results in additional income, and will offset any expected declines in the stock price. The option seller is “covered” against a loss since in the event that the option buyer exercises their option, the seller can provide the buyer with shares of the stock that he has already purchased at a price below the strike price of the option. The seller’s profit in owning the underlying stock will be limited to the stock’s rise to the option strike price but he will be protected against any actual loss.

2. Naked Call Option

A naked call option is when an option seller sells a call option without owning the underlying stock. Naked short selling of options is considered very risky since there is no limit to how high a stock’s price can go and the option seller is not “covered” against potential losses by owning the underlying stock. When a call option buyer exercises his right, the naked option seller is obligated to buy the stock at the current market price to provide the shares to the option holder. If the stock price exceeds the call option’s strike price, then the difference between the current market price and the strike price represents the loss to the seller. Most option sellers charge a high fee to compensate for any losses that may occur.

Call vs. Put Option

A call and put option are the opposite of each other. A call option is the right to buy an underlying stock at a predetermined price up until a specified expiration date. On the contrary, a put option is the right to sell the underlying stock at a predetermined price until a fixed expiry date. While a call option buyer has the right (but not obligation) to buy shares at the strike price before or on the expiry date, a put option buyer has the right to sell shares at the strike price.

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