Explain options and calls to me

[disneysteve]

There has been some talk lately of options and covered calls. For me and others who don't know about these, can someone give a basic description of how these things work, what costs are involved, what the risks and benefits are?

[KTP]

Come over to the dark side, Steve!

There are four things you can do with options where you won't lose your home.

Buying Calls
Buying Puts
Writing Covered Calls
Selling Cash Secured Puts

Calls are bought just like you were buying the actual stock. They give you the right to buy the stock at the strike price up until the day they expire. If the stock goes up, they usually go up. As the days get closer to the expiration, the "time" value of the call goes down. This makes sense. If a stock is trading at $30 and you have call that expires the next day for a strike price of $29, it is going to only be worth about $1, as there is not much time until expiration. If the stock were trading at $30 and your $29 strike call did not expire for 3 months, it might be worth as much as $2 to $3. You can never lose more than what you paid for the option. When you buy the options you use the term "buy to open" and if you want to sell an option before expiration (without exercising it) you can sell it to the market with a "sell to close" order. Selling a call option back to the market using a sell to close order gets you totally out of the picture, no further liability. American calls are sold in lots of 100 called a contract. One April 11 $30 call selling for $1 would cost you $100 and represent $3000 worth of stock. Your leverage is then 30:1, meaning a 1% movement in stock price would probably move your option by as much as 30% (maybe...depends a lot on the time value and other things).

Puts are similarly purchased and sold like calls, except they give you the right to sell a stock at a certain price (the strike price). If you bought a put on xyz company for $30 strike and over the next few days the market tanks and the stock is trading at $25, then your put is worth $5 plus some time value. Just like the calls, you "buy to open" a put and "sell to close" to sell the put back to the market without actually having to buy the underlying stock at the strike price. American puts are sold in lots of 100 called a contract. One April 11 $30 Put contract selling for $1 would cost you $100 and represent $3000 worth of stock.

Covered calls are when you are the one selling the call option contract to the market, guaranteed by existing stock you have in your account. You must have at least 100 shares of stock so that you can sell at least 1 contract (which represents 100 shares). If you have 100 shares of XYZ corp trading at $100, and you sell some July 11 $105 contracts for $6, you will immediately receive $600 in your account for the 1 contract and your 100 shares will be locked up until the expiration date or they are called away from you at $105 (at which point you would also get paid $105 for each share). You always get to keep the $600 and thus can spend it on hookers and coke or whatever.

Cash secured puts are where you agree to set aside an amount of money in an account that guarantees you will purchase shares of a company at a certain price (the strike price). For example, if you sell one cash secured put contract for XYZ corp at a $95 strike price for $5, then you must have $9500 in your account to cover buying the 100 shares if they are eventually sold to you by the exercise of the put. You would immediately get $500 for selling the put contract that you could spend on even more hookers and coke or whatever. If XYZ corp goes up in price, you will never get sold the shares and your $9500 will be released. If XYZ corp goes to $50, then you will own 100 shares of the company for your $9500, although it would have a current market value of $5000. I prefer covered calls over cash secured puts because with covered calls, since you own the actual shares, you get dividends. Plus I believe over the long term markets generally go up (we don't expect the market to be DOW 500 in 20 years, do we?)

Well that was a lengthy but simplistic starter on options.

[jpg7n16]

So Steve here's a good example of the general idea.

I own some PG stock, and you like my P&G stock. Now you'd like to buy it, but you're not sure how the price will do over the following 2 years - and before you commit to buying, you really wish you had a chance to see how the stock would perform.

So I come along and say, 'hey - how about this? If you pay me $5/share today, I'll guarantee you that you can CALL me up and buy my PG shares at $65 any time between now and the end of January 2013.'

You really like PG and think it'll go up to $75 if not higher! So you agree.

That way if the stock goes way down to say $50 or 55, you're only out $5/share, and if it goes up you can buy for $65/share from me - when it may be trading at $75/share in the market.

In that scenario, I wrote the call option because I wrote the contract giving you the option. (option not requirement)

And in that scenario, you were the buyer of the call option, cause you paid money (bought) the priviledge of having an option.


Also in that scenario, say that PG shot up to $80 and you chose to 'exercise' your option. Remember you weren't required to.

Now I'm required by contract to sell my shares to you for $65 (when I could have sold them on the market for $80). So my final selling price is $65 plus the 5/share from where we made the deal. $70

You would get a cost basis of $65 plus the cost of the contract $5/share = $70

And an astute observer would notice that you don't actually begin to profit until the stock gets above $70/share. That's your break-even point (strike price + premium)


Those are actual option prices on PG today: (or well it's close - hey I'm offering a deal!!)
options by expiration - Google Finance
Change it to expires Jan 19, 2013

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Or the simplistic version:

Calls - bets that the stock will go up
Puts - bets that the stock will go down


For the specifics of account requirements, see KTPs post above.

I think they're cool - cause I can leverage a smaller amount of cash and control the same number of shares. I mean in the example I just gave, you could control $6500 worth of PG stock for $500 (100 shares). For 2 whole years! Your max loss is fixed, and the higher it goes, the more you profit.

Oh and each contract is always for 100 shares. They're standardized that way. This was mentioned in KTPs post as kind of an aside, but you can't change that. It's either 100 shares or 0.

[jpg7n16]

Covered calls are when you are the one selling the call option contract to the market, guaranteed by existing stock you have in your account. You must have at least 100 shares of stock so that you can sell at least 1 contract (which represents 100 shares). If you have 100 shares of XYZ corp trading at $100, and you sell some July 11 $105 contracts for $6, you will immediately receive $600 in your account for the 1 contract and your 100 shares will be locked up until the expiration date or they are called away from you at $105 (at which point you would also get paid $105 for each share). You always get to keep the $600 and thus can spend it on hookers and coke or whatever.

Oh and they're called 'covered' as opposed to 'naked'. Not joking.

Covered calls are where the contract is secured by actual shares (as in my example and KTPs post)

Naked calls are where there is no actual security backing the contract.


If PG went up to $80, and I wrote you a covered call; if you exercised, I'd just sell you my 100 shares for $65/share.

If PG went up to $80, and I wrote you a naked call; if you exercised, I'd have to go buy 100 shares in the market for $80/share - and then immediately sell them to you for $65/share.

[KTP]

Oh, one other thing we should mention is how commissions are usually done on option trades...

When you buy a call or put, usually you pay a flat fee plus a fee per contract. For example, at Etrade, buying an option or put costs you $9.95 plus $0.75 per contract. Since a contract represents 100 shares, you are actually paying $0.0075 per share (plus the flat $9.95 fee). What this means to me is that trading options can be expensive on far out of the money calls or puts. Example: Say you want to buy Feb 11 $30 calls on XYZ corp whose stock is currently $20. The option contract might be going for as little as $0.05, but remember, you are going to be paying $0.0075 per share in addition to the $9.95. Technically, you could buy 100 of these Feb 11 $30 calls for only $500 total...wow, you would be controlling 10,000 shares of XYZ for $500...but you would pay $9.95 + $75 = $84.95 in commissions!!! both when you bought and if you sold later!!! A pretty horrible fee, unless of course XYZ goes to $50, and then you are like a millionaire

This is why I try to buy contracts that are around $1 or so. Then the fee is about 1% or less of the total cost of buying or selling. (one contract at $1 would be $100 + $9.95 + $0.75, or a total out of pocket of $110.70).

I got upgraded at Etrade due to my leet trading skills (or maybe I just met their 40 trades per quarter quota, doh!) and now my options trades are $7.95 + $0.75 per contract. Not much of a discount.

Now do you see why getting 100 free options trades (or normal trades) at optionshouse is such a big deal to me? It potentially is worth hundreds or thousands of dollars in saved commissions!

An example. Today I shorted Las Vegas Sands (LVS) right at the close by buying a Feb 11 $35 put for $0.23 (really far out of the money, since LVS is near $50 now). This cost me $23 per contract, or a total of $230 (I bought 10 contracts). It is kind of complicated why I did this, and the money is probably lost, but what I wanted to experiment with is sort of an insurance policy for all of my other long call options in this small optionshouse account. I am fairly confident of my bets through Jan earnings, but there is always the slight chance that something big will happen and the whole market will tank. If it does, LVS is going to crash hard (maybe droppping to $25) and the $10,000+ I would then make off of this one put that cost me a total of $230 would more than cover my now worthless calls (the optionshouse account was started with $3000 and is now worth $5500 after a few weeks due to some nice option plays in MSFT, CSCO, and FRO. A good example of when you might want to use puts. Of course I am just a baby options trader, and may not know what the hell I am doing...

[jpg7n16]

For anyone considering options, I'd highly recommend going through this 'course' on Investopedia.

Options Basics: Introduction

[Slug]

Just got my GM shares that I bought at the IPO called on Friday. I think GM's going higher but forced myself to make it a short term trade. Left about $100 on the table due to the call and quick run up, but that's the risk you take.

[buildmybudget]

KTP, I looked at the optionshouse website. Is the software as it says--easy to use? I've been interested in opening a similar "play" account like you have since I've been trained somewhat in options and futures. Now that I'm done with school I've been studying up on everything so I can open the account and it seems like optionshouse could be a great place to open it.

[KTP]

KTP, I looked at the optionshouse website. Is the software as it says--easy to use? I've been interested in opening a similar "play" account like you have since I've been trained somewhat in options and futures. Now that I'm done with school I've been studying up on everything so I can open the account and it seems like optionshouse could be a great place to open it.

I haven't used some of the fancier stuff for writing spreads and such, but it does seem easy enough to trade. They even give you a fake money account to practice which uses real time data.

I have used up 35 out of my 100 trades already lol....things like buying 100 shares of JASO at $6.80 and selling at $7.50 (only to see it trading at $7.80 today..doh).

Make sure to use the link and code FREE100 when you sign up so that you get the free trades.

[Scanner]

I'm still trying to figure out the whole thing too, DS. . .but it does seem a lot of options and calls are about hedging, maybe equally so as much as speculation (which is what I would more interested in).

I know a lot of companies will use futures and options to hedge and manage a business.

For instance, you are an oil co. that delivers oil to customers for heat. You charge $3.00 gallon but you have to stock inventory at that price and buy ahead. . .well, if oil goes down, you've perhaps bought high and now have to sell to your customers high, because now the competition has had it delivered to them at a lower price 4 weeks later.

So, the CFO may buy "futures" contracts on the idea if it drops, you've made a "killing."

I am convinced that what these oil companies do with your money when you buy price protection plans - probably pool it and buy future contracts. I guess mutual fund managers use options probably a little the same way.

(as usual, I understand commodities more than stocks)