Tuesday, September 11, 2007

Review Your “Options”: Calling and Putting

Author: Nick
Category: Money
Topics:

not pictured, turning left takes you to margaritaville

by Valerie March

To make money in the stock market, you don’t have to actually buy any stocks.

“Wait. Wha…?”

No, seriously, it’s true: there are things call stock options, which are simply contracts between a buyer and a seller that outline prices and time periods for buying or selling a security, most notably stocks.

It sounds too good to be true, but with stock options, you can often pay pennies on the dollar to make money on your favorite companies with two basic types of options, “calls” and “puts.”

If you’re sure a stock, index (think S&P 500 or the NASDAQ), or commodity is going up, you should purchase a call option. When you think a stock or security is going to fall, you should buy a put.

A call offers the right, but not the obligation, to buy a stock at a given price for a set period of time. Calls act very much like discount coupons for stocks that investors already like and want to own. Each options contract gives you the right to buy 100 shares under the terms of the option contract.

Let’s look at an example to see how you can make money on calls with hypothetical stock for the Fun Company, whose stock symbol is FUN. FUN is currently trading for $45. But, you think FUN is going way up, so you buy the FUN December $45 Calls, which are selling for $2. With this FUN call option, you’re betting that the Fun Company’s stock, also called the underlying, will climb above $45 before the option expires in December.

When FUN shoots up to say $50, the call option gives you the “option” (get it?) to buy FUN stock valued at $50 for only $45.

Or, if FUN does go up, but you don’t want to buy the stock, you also have the option to sell your FUN December $45 Calls anytime before they expire in December. By selling, you’re releasing your right to buy shares at the $45 strike price to another trader, but with FUN performing well, the value of the option will also increase and you will likely get a nice profit now that the calls are now worth, say $10.

Again, the cost of purchasing options is far less than buying the underlying stock. For the FUN December $45 Calls, which you bought for $2, you must multiply the $2 selling price by the 100 shares per contract: The total output is $200. If you were buying 100 shares of FUN stock, you would be out $4,500.

In addition to lower output, options allow investors to make money when the overall market, sectors or individual stocks fall, simply by using puts. That’s right—with put options, you can make money when stocks tank.

Puts offer the right, but not the obligation, to sell a stock at a given price for a set period of time. Again, each put option offers investors the right to sell 100 shares under the terms of the option contract.

When purchasing puts, you still want to see the value of the options go up, but at the same time, you want the stock to bomb bigger than Daddy Day Camp. Staying with the Fun Company example, if you think the $45 share price will go lower, you might buy the FUN December $40 Puts.

This would now give you the right to sell FUN stock at that $40 price—or, said simply, you’d have the right to put stock to the put-seller at $40 a share, even if FUN trades down to $35. Yes, the suckers would have to pay you nearly $5 per share more than the market value if you’re right!

And again, if you don’t want to take advantage of selling the stock, if the value of the options increases, you can sell your right to make that move by closing (selling) the option position. If your prediction about the direction of the stock and the option were right, you stand to profit either way.

There are endless ways to use options to profit in any kind of market without actually buying a single stock. Most importantly, options investing gives you, well, options and they’re great tools to profit in markets that are going up, down, or sideways.

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Valerie March works at a financial publisher and frequently goes up, down and sideways. She is currently trying to find new and interesting recipes for her abundance of zucchini. If you have any ideas (zucchini-related or otherwise), please leave a comment.

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