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Buying Puts

Suppose you look at XYZ stock and think to yourself, “Now there’s a train wreck waiting to happen.” You can see that the price is going down soon -- but how can you make a profit when a stock loses value?

A put option allows you to do just that. It’s basically buying a call option in reverse. Let’s say that XYZ stock is trading for $10 a share in June. You just know in your bones that it’s going to tank by August. You buy the XYZ August $12.50 put option for $2 a contract. Your $200 now buys you the right to sell, or put, 100 shares of XYZ, at $12.50 a share, anytime before the third Friday in August. You do this because you fully expect it to drop like a stone – possibly all the way down to zero.

Let’s say you were right on the money. XYZ is a dog and falls to $5 a share. You can exercise the put and sell 100 shares of XYZ at $12.50 – then buy 100 shares of XYZ at the current price of $5 for a profit of $7.50 per share, minus the $200 you paid for the option, and commissions. Unlike a call option, in which you first buy and then sell, those who exercise put options sell the stock first -- and then buy the stock back at a lower price to complete the transaction. If you don’t want to hassle with buying and selling stock, you may simply choose to sell the put options, which rose in value when the price of the underlying stock fell.

But here’s the corresponding risk: say you buy one XYZ August $12.50 put contract at $2. A week later XYZ shoots up to $15 a share. You’re now in the red, and your losses only mount as XYZ continues to climb. You must then sell your put option at a loss or let the contract expire worthless

Buying Call Options

Let’s say it’s June, XYZ is trading at $10 a share and you think it will go much higher by August. You don’t have the money to buy 100 XYZ stock shares at $10 a share, but the XYZ August 12.50 options calls are selling for $2 a contract. You see that one options contract controls 100 shares of stock. You choose to buy one XYZ August $12.50 call option at $2 a contract. You pay $200 -- $2 x 100 shares.

Your $200 buys you the right to buy 100 shares of XYZ stock at $12.50 a share anytime between now and the third Friday in August, when your contract will expire.

A week later XYZ stock shoots up to $16 a share. Congratulations! Do you exercise your option now and buy 100 shares of XYZ stock at $12.50 a share? Usually not. Wouldn’t you be making a profit? Yes – barely. You’d be making $350, minus the $200 you paid for the options, minus commissions for the stock trades. But why do all that -- look at the price of your XYZ options! They’ve also risen – let’s say, to $4 a contract – $400 minus the $200 you paid for the options = $200 profit in one week!

You see, when the underlying stocks rise in price, the value of your call options usually rise as well – and since the options cost far less, you can afford to load up on them. Translation: Options can make you a lot of money, very quickly, with only a small initial investment. But only if the price of the call option rises high enough – and within the timeframe you chose!

Here’s the other potential call option scenario, this one not so pretty: You choose to buy one XYZ August $12.50 option contract at $2 a contract. You pay $200. The price of XYZ stock plunges to $5 a share – far below your strike price. It stays there well into July. You’re now faced with a hard choice – sell your options for a big loss while you still can, or ride it out, hoping that the stock will rebound. If you still hold your contract on the third Friday in August, it will expire worthless – and you’ve lost the whole $200!

This possibility is why many brokerage firms advise their novice clients to avoid options trading – at least until they learn enough to assume these risks knowledgeably.

Selling Puts

Say it’s June, and you own 100 shares of XYZ stock, which is stuck at $10. The market is stable and you’re pretty sure XYZ is on its way up soon, but it isn’t going anywhere at the moment. You’d like to make some money off XYZ while you wait for the move, but you don’t want to sell a call option, since you believe the stock may rise in price. You see that the XYZ August $10 put options are selling for $2. You sell one put contract and receive a $200 premium from the put buyer.

If XYZ rises above $10, you keep both your stock and the $200 premium, since you’re unlikely to get called out when your stock is at, or above, the put strike price.

If, however, you misjudged either the market or XYZ, and the stock falls below your strike price of $10, the option may be exercised, and you may be forced to buy 100 shares of XYZ stock at $10 a share. The amount of your loss will then depend on how low XYZ falls before you can sell it and get out of the trade.

As you can see, options are versatile investments. These examples are only the most basic of the potential options trading strategies available. It’s important to note that since options are perishable commodities, and since it’s possible to lose money with them very quickly, it’s not advisable to trade them until you have a good grasp of what they are and how they work.