Stock Options - Understanding the Basics:
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There are two types of options:
A Call Option and a Put Option
The purchase of a call option provides the buyer with the right - but not the
obligation- to purchase the underlying item at a specified price, called the
strike price or exercise price, at any time up to and including the expiration
date.
A put option provides the buyer with the right- but not the obligation- to
sell the underlying item at the strike price at any time prior to
expiration.
The price of an option is called the premium. As an example of an option, an
IBM April 130 call gives the purchaser the right to buy 100 shares of IBM at
$130 per share at any time during the life of the option.
The buyer of a call seeks to profit from an anticipated price rise by locking
in a specified purchase price. The call buyer’s maximum possible loss will be
equal to the dollar amount of the premium paid for the option. This maximum loss
would occur on an option held until expiration if the strike price were above
the prevailing market price.
For example, if IBM were trading at $125 when the 130 option expired, the
option would expire worthless. If at expiration the price of the underlying
market was above the strike price, the option would have some value and would
hence be exercise. However, if the difference between the market price and the
strike price were less than the premium paid for the option, the net result of
the trade would still be a loss. In order for a call buyer to realize a net
profit, the difference between the market price and the strike price would have
to exceed the premium paid when the call was purchased. The higher the market
price the market price, the greater the profit.
The buyer of a put seeks to profit from a market decline by locking in a
sales price.
The option buyer accepts a large probability of a small loss in the return
for a small probability of a large gain.
But what if you had a way of trading options where the probability of a large
gain was high?
What if you had a system that would make money regardless of which way the
stock moves as long as it does in either direction you will make money? Think
you could make some serious money?
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