Quote:
Originally posted by brainsmile
you're purchasing the right to buy a stock at a future price. So the less probable that price is the cheaper that option.
For instance if a stock is 10 bucks and it's the first of the month and you buy an option to purchase the stock for 30 bucks (keep in mind the option expires in about 3 weeks) then the only way to exercise it is if the price is above 30 bucks on the day the option expires. It's going to be cheap to buy this option because the likelihood of this happening is very low.
Same thing on the sell side... if the stock is 30 and you buy an option to sell at 10... the stock has to be below 10 on the day of expiration. Should be cheap to buy. It's sort of insurance that you'll get a better price.
If the option expires you lose the money you put in. Of course you can sell the option at any time. If for instance the next day, after you buy a call option to buy at 30, the stock has great news and jumps to 28. Well then the likelihood of it passing 30 is much higher and the value of your option to buy has increased dramatically. Then you can sell the put and make a profit without ever exercising the option.
I think this is right.
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That is a perfect explaination.
Kenas, your explaination is somewhat misleading. Options are no different than stocks in the idea that somebody ALWAYS loses. Stocks and options are zero sum gains, for every winner there is an equal loser.
Options have tremendous ability to make a ton of money. Utilizing a strong leverage position with options, an investor with a good nose for a stock can pick out a stock that is under-valued, set down a small chunk of money, wait for the option to hit the strike price and then exercise it.
The price at which you purchase the underlying stock is the strike price. Lets say you buy an option for $3 on AOL to strike at $60. Thus, in order to break even, your stock would have to hit $63 (strike+cost of option). Anything above 63 will be profit.
If you buy a put option (right, but not obligation to sell) and you hold AOL, it protects you from a downside. Thus, if you have a put option with a 57 strike, if AOL went to $50, the person who sold the put option HAS to buy your stock for $57 if you want to sell it. Your breakeven point is $57 (60-$3), any price below that you can buy AOL on the market (say at 54) and sell it at 57, netting $3 profit.
You can sell options to make money. This is VERY risky. Buying puts and calls limit you to a downside of ONLY the purchase price of the option. However, selling options HAS UNLIMITED DOWNSIDE (for calls) and a lot for puts. For example, if you sold a put option to a guy who has AOL, its exercise price is $57 and AOL tanks to ZERO, then you HAVE to buy that stock for $57, the purchaser could buy 100 shares (most options are for 100 shares standard) of AOL at ZERO and sell it to you at FIFTY SEVEN, thus you lose $5700.
If you sell a call, your downside is unlimited. If you sell AOL call for $3, strike of 60, then AOL goes up to $100, that person can buy AOL from you fro $60 and sell it on the market for $100, making $40 for every share and a total of $4000 profit.
Breakeven points for selling a call/put is inverse to buying them. If you sold a call, your breakeven is $57 (covered call) and priceStock-PriceCall.
An option is "In the money" when its current stock price is ABOVE (or below for put) the strike price. It is "At the money" when the underlying asset is AT the strike price. It is "out of the money" when the stock price is BELOW (above for puts) the strike price.
There are two basic types of options, there are American and European options. American options can be exercised AT ANY TIME. European options can only be exercised at certain points in the life of the option.
The 3rd friday of March, June, September, and December is known as "triple witching" day. This is when option dates expire and often leads to massive variations in stock prices.
------------USES OF OPTIONS------------------
Options are EXTREMELY useful if you think you know something the market does not (or you know you know something). Most often, options are used in regards to insider trading. This is because options are dang cheap when they are "deep out of the money" This means that a call option (right to buy) has a strike price WAY above the current asset price. If there is sudden news that a company is doing well, then the option price increases MORE than the asset price.
When an option is deep out of the money, its price fluctuates 2-3x more than the underlying stock. Thus a 10% increase in stock price that moves a DOM option nearer to the strike, the option price might increase 30-40%. Once a option becomes "in the money" it moves 1-1 with the underlying asset prices.
There was one case where some guys bought 5000 DOM options (total of 500,000 shares) on a drug company because they knew a drug would get approved. They bought them for .50. When it was done, each option was worth $6 or so. This means their initial investment of $2500 was worth 30,000, and that was only with a 15% increase in the stock price.
Options can also be used as a "protective put", which ensures that if a stock goes down, you are protected from it going too far down. This is basically insurance, you pay a premium to get protected from bad stuff, and you are paying somebody else to assume the risk.
There are many different combinations of option strategies. You can sell a put and a call option, which is called a butterfly. You make money off of the comissions, maximizing your profit when the stock doesn't move anywhere. Thus, if the strike for AOL was 60 and at the expiration, AOL stock was at 60, you just gained $6. However, if the stock goes up or down past $6, then you have unlimited downside risk.
If you buy a call and buy a put, then any time a stock moves beyond the combined price of the options, then you have unlimted profit. Loss is limited to the combined option prices.
There is also a Bull/Bear spreads, where you sell the more valuable option and buy a cheaper option. Depending on which way you think the market will go, you will make money off of the price spread between the two options.
You can also create synthetic options by combining option+stock positions. If you buy a stock and buy a put, that is equal to a call (unlimited upside and very little down (downside is only the option premium of the call).
You can also buy a call and short sell a stock. Thus, if the price of the stock goes down you can have unlimited gain. However, if it goes up you are protected from losing too much since you can buy at a low price to cover your short, this is a synthetic put, it protects you from downside risk.
I can't think of all of the spreads, but there are a bunch that I have to start remembering for my exam. If you need any other info lemme know.
But back to investing with options. Larger price movements are to your advantage, as is fundamental analysis that point to a large over/under valuation of a company.
Options are cheap way of taking advantage of this type of information. If you are right and a stock fly's up, then your earnings are multiplied MUCH faster than if you had bought the stock (leverage effects). If your wrong, you are limited to the comission (if you were buying calls/puts).
I WOULD NOT sell options, as it can get you into MASSIVE trouble if you aren't careful and know how to hedge yourself very well. Options are just like futures in the fact that if you are on the right side, your earnings are multiplied due to leverage. However, if you are on the wrong side, your losses are multiplied also.
When I Was playing a stock game for my derivatives course I made a ton of money off NVDA since they had some negative earnings announcements which drove their price down. I had bought put options that became VERY valuable quickly.
LK