After
explaining Options, we will discuss how you can develop a
system designed to manage your money to prevent you from
large losses, when trading Options.
What are stock options?
Let's assume we are talking about the stock, Dell Computers.
A stock option gives you the right to buy or sell a particular
stock at a certain price for a limited period of time. The
stock (Dell) would be known as the underlying security.
There is a call option and a put option. Each of these stock
option contracts represents 100 shares of stock.
If you purchased the call option, you as the owner, have
the right to buy the underlying security (Dell). When you
buy a call option, you are hoping the underlying security
goes up.
If you purchased the put option, you as the owner, have
the right to sell the underlying security (Dell). When you
buy a put option, you are hoping the underlying security
goes down.
An option has what is called the striking price, which is
also known as the exercise price. The strike or exercise
price is the price per share at which the holder of an option
may buy(call) or sell(put) the underlying security. Each
option has an expiration date.
You want to keep these four terms in mind as we go through
the series.
1. call or put
2. underlying security name
3. striking price
4. expiration date
Now let's use an example using the above terms.
Using Dell as my underlying security, I check and see that
dell is $100(we will use these figures as examples). I'd
like to buy 100 shares of Dell, which will cost me $10,000.
But wait! I don't have $10,000!
Darn! I heard Dell might be a good investment. Not to worry,
I check on the options. Options have different months and
dates that I can purchase. I check the different months
and decide on the April 2002 month, simply because this
is October and I want about 6 months for Dell to rise.
Then I check on the strike prices. Since Dell is $100 and
I have 6 months to work with, I look at various strike prices
in the month of April. I look at the April 90(for the month
of April at 90 dollars per share), April 100, and April 105.
Each of these striking prices will have a different cost.
The 90's will cost $13.00; the 100's cost $9.00 and the 105's
cost $6.00. I decide on the April 100 for $9.00. (The reason
I decide on this strike price will not be discussed here.
We will discuss that in a subsequent article).
I purchase one April 100 call contract (giving me the right
to buy 100 shares of Dell at $100 anytime prior to April
expiration) for $9.00 per contract. This will cost me $900
plus commission. In our example we explained that to purchase
100 shares of the stock directly, at $100 per share would
be $10,000. We all know there is a major difference between
$10,000 and $900. This is known in the investment world as
leverage.
We need to understand, however, that
an option is a "wasting" asset.
This means that it declines as time passes. Therefore, there
is a risk here that we can lose our $900 if dell closes in
April 2002 at or below $100. Yet the $900 is all we can lose.
Let us assume we are going into a bear market and dell drops
from $100 to $70, a $30 drop.
If we had bought 100 shares of dell at $100, we would have
a $3,000 loss. With our option purchase we could only lose
$900. However, we want dell to go up because we bought a
call option.
Let us also assume that we move into a bull market and Dell
rises to $125 by December. You as holder of the April 100
call have three choices.
1. You can exercise your right to buy Dell at $100 giving
you a $2500 profit.
2. You can sell your option outright which would give you
a profit of at least $2500
3. You can hold your position for more profits, if you think
Dell is going to continue to move up.
Summarizing, you can use Options for leverage and the risk
that Options have, are not any more risk than buying stock
outright, IF you know how to manage your money, with your
trades.
We'll get into the put options in the next article
Previous Options Articles:
Options Start
Options Article 1
Options Article 2
Options Article 3
Options Article 4
Options Article 5
Options Article 6
Jenyce Johnson
Options Strategist, Trader and Coach
Not a licensed professional
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