October 10, 2017

Calls and Puts: What You Need to Know

Read more about Options Trading

Making money predicting a stock's future is possible. It's called trading options. Options help you gain leverage while using less capital.

Sounds promising, but as a beginning investor, should you dabble in calls and puts?

Read on to see what they mean and what you stand to gain or lose.

Why Should You Trade Calls and Puts?

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Trading puts and calls is similar to betting. You take a "gamble" by paying a premium for the right to buy shares of a stock at a specific price by a certain date (call option) or for the right to sell it (put option). Your "bet" is that the stock price will go up or down within the set time frame.

Betting is risky, though. Why would you want to take a chance?

It's all about leverage. When you invest in options, you are using less of your money to access a particular stock than if you bought (or sold) the shares outright. And you stand to gain more value from your purchase in the end.

What if the stock's price doesn't rise as much as you thought (or go down if you were planning to sell?). If the deal flops, you lose your premium. You don't have an obligation to buy or sell a stock. An option gives you a "right."

If you bought the shares, though, you would lose a lot more than just your premium. Of course, the amount you bet affects how big or small your losses become.

If, however, you sell a call or put, you have the obligation to trade. This is where it gets riskier. You aren't calling the shots. The buyer (holder) calls them. It can still be profitable when things go right. It can also be detrimental if things go wrong.

An investor who puts it all in options premiums stands to lose it all. If you are smart and diversify by investing in different types of options, investments, and types of companies, you put some of your money at risk (but not all of it).

If you have experience in trading stocks and do your research, options might be a good addition to your portfolio. Should you make your entire portfolio options? We don't recommend it. But, if you have the right support, options may help you increase your earnings potential.

What Should You Know About Call Options?

When you want to buy a stock at a specific price, you buy a call option. Investors use this strategy when they think a stock's price will increase. If it does, they can buy the stock at the strike price of the call. They can then sell it at the higher market price and make a profit.

You can also sell a call option. The writer (aka the seller) thinks the stock's price will decrease. If it does, the writer walks away with the premium. The contract expires worthless. If the price increases, the writer stands to lose money. This is especially true if he sells an uncovered call (he did not own the stock).

What Should You Know About Put Options?

Investors buy a put option when they think a particular stock's price will plummet. It gives them the right to sell at the strike price. If the market price falls, the investor can exercise his right to sell at the higher price.

Experienced investors can also sell a put option. Investors who write put options think the stock price will increase. If it does, the contract expires worthless, and the writer keeps the premium. If the stock price decreases, the buyer may execute the contract. And the writer is then required to buy the stock at the strike price. This leaves you open for significant loss.

How to Make Money with Options

There's no guarantee that you'll make money with options. It depends on how the market reacts. But, if things go right, you may reap great rewards.

Investors who buy more than 1 options contract stand to make the largest profit.

For example, let's say you can buy ABC stock for $40. You have enough money to buy 100 shares at $4,000. If the stock tanks, you lose your money. If it increases, you make a profit. It's very black and white.

If instead, you bought an options contract at a $2 premium, you'd pay $200. At this price, you could afford 20 contracts. This is where it gets interesting.

Keep in mind that you don't have any stock ownership with options. What you have is an opportunity for when, hopefully, the price of a stock goes your way.

Let's say you bought a call with a strike price of $40. The market price increases to $50. You execute your 20 options contracts. You make $10 per share and you have 100 shares. You also have 20 contracts, so that's 2,000 shares. At $10 profit per share, you made $20,000 minus the $4,000 premium.

If you stuck with the stock ownership, you would still have made $10 per share, but you only held 100 shares. You would have a profit of $1,000 rather than $20,000.

Now, let's look at a put. We'll use the same ABC stock with a $40 current market price. This time, you think the stock's price will fall. You buy put contracts with a strike price of $40 and a premium of $2. You buy 20 contracts paying $4,000. This gives you the right to sell the stock at $40 if the market price falls.

If the market price falls to $30, you execute your contract. Again, you made $10 per share. You have the right to sell 2,000 shares with your 20 contracts. Initially, you make $20,000. But, you must consider the $4,000 premium paid. You walk away with a $16,000 profit.

If you bought and sold the stock on the stock exchange, with a $40 initial price and a final price of $30, you would have lost $10 per share. At 100 shares, that's a loss of $1,000.

How You Can Lose It All Trading Options

To be sure, trading options takes a lot more knowledge than trading stocks. Anyone can take a chance and buy a stock, hoping for the best. Trading options, however, requires knowledge not only about the company you're investing in, but also knowledge about timing, making smart predictions, and how to carry out transactions. You also need to know how to read historical charts and look for patterns.

And you need a coach. Your coach is your brokerage firm. You need someone who's been through it. Trading options only gets better through experience. A broker will have tried and proven strategies. You can use those strategies along with your own to create the options trading plan that works for you.

Remember, trading options can be a lot of trial and error. You could end up with some pretty big losses up front. Diversification has historically been the key way to avoid financial destruction.

The Final Word

Trading options is serious business. You must do your research. You also need a supportive broker on your side. While they do provide the potential for incredible reward, they also allow for financial ruin. Dabbling in options can help you get a feel for the market one way or the other. Beginning investors often start by buying a call.

Your broker must approve you for any options transactions. They'll help you start small and build your way up. As you gain experience, you'll learn the ins and outs of calls and puts.

More from CreditDonkey:

Call Options

Put Options

How to Trade Options

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