Buying Options

Introduction

Now that you understand some of the basic terminology and concepts used in options, let's focus on the specifics of option buying.

When you own an option it is entirely up to you whether or not to exercise the option and take advantage of the right granted to you as holder of the option. Because you have this control, your risk in buying an option is always limited to the cost of the option itself.

In learning about buying options, you will need to understand two key concepts: how to use call options to create leverage, and how to use put options as a way to protect a long stock position from a sudden drop.

Exercise

When you take advantage of the right granted by your option, it is known as exercise. If you exercise a call you buy the stock at the option's strike price. If you exercise a put, you sell the stock at the option's strike price.

American Exercise options, which are the vast majority of options traded in the U.S., allow the holder of the option to exercise anytime before expiration. In contrast, holders of European Exercise options can only exercise during a specified period of time just prior to the options' expiration.

In both cases expiration occurs on the Saturday following the third Friday of the month. However, because the exchanges are not open on Saturday, trading actually stops on the preceding Friday.

You should also note that different brokerage firms have differing policies regarding the automatic exercise of options in-the-money at expiration. Here, all options at least 0.25 point in-the-money are automatically exercised at expiration.

Options as Leverage

Leverage is the term used to describe the use of a small amount of money to control a larger asset.

Although debt is the most common form of leverage, options are another type. In the case of options, leverage creates greater percentage of returns and losses without increasing the dollar amount of the investment.

To illustrate, imagine that it's May and you are bullish on Gro-Grub (symbol: XYZ). You are considering buying either 100 shares of XYZ for $35 or 1 XYZ JUN 30 CALL for $6.

Remembering that one option contract controls 100 shares of stock, the cost of the option is $600 while the cost of the stock is $3,500. The table compares the returns and losses of the two investments at the option's expiration.

Buying Calls

If you think a stock is going to go up, you can buy calls.

Imagine it is May and XYZ is trading at $33 when you decide to buy 1 XYZ JUN 30 CALL for $4. If XYZ went up, so would your option. For example, if XYZ increased from $33 to $38, your call would also increase from $4 to perhaps $9. In both cases the asset has increased by $5, but that is an increase of 125% in the option and only 15% in the stock.

Conversely, if XYZ went below $30, the option would be out-of-the-money and its value would decline toward zero as it neared expiration, costing you 100% of your investment.

Buying Puts

If you are bearish on a stock, you might want to buy puts.

To illustrate put buying, imagine it is May and XYZ is trading at $33 when you buy 1 XYZ JUN 35 PUT for $3. As the price of XYZ declines, your put becomes more valuable. For example, if XYZ dropped from $33 to $30, your put would increase from $3 to around $6. In this case a 10% drop in the stock could cause a 100% increase in your put.

Conversely, if XYZ rallied and then stayed above the $35 strike price, your put would be out-of-the-money and decline in value as it neared expiration. Of course XYZ might also fluctuate wildly before expiration, giving you various opportunities to sell or exercise your put.

Married Puts or Puts as Insurance

You can also use options as insurance against downturns in the price of a stock without losing the upside potential of stock ownership. You do this by purchasing married puts. To create a married put you buy puts on a stock you already own. This allows you to sell your stock at the put's strike price anytime before expiration.

Imagine that you own 100 shares of XYZ, purchased at $30 a share. With XYZ at $36 you have an unrealized gain of $600; however you now have short-term concerns. By purchasing 1 XYZ JUN 35 PUT for $2, you acquire the right to sell 100 shares of XYZ, the same number of shares that you own, for $35 anytime before expiration while also retaining ownership of your stock.

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Selling Options