If you have ever been involved in a conversation with finance professionals before, you will find that it is littered with financial jargon. Whether you like it or not, you need to at least grasp the fundamentals to be able to swim in this deep ocean called the market.
Trading options is no less different! The first two terminologies that you absolutely have to understand is the call and put options.
1. Call options, or “calls” – For each call contract you acquire, you have the right to BUY “X” number of shares/asset from the seller at a specific price within a specific time frame. For example, the current price of shares of ABC Company is $50, and you believe it will rise in 3 months. You then purchase a call contract at $5 that gives you the right to purchase 100 shares of ABC Company shares for $50 dollars in 3 months. After 3 months, the stock price rose to $60! You exercise your call options to purchase 100 shares of ABC at $50, the agreed price in the contract. Your profit is ($60 x 100 shares) – ($50 x 100 shares) – ($5 contract cost) = $995.
2. Put options, or “puts” – For each contract you acquire, you have the right to SELL “X” number of shares/asset to a buyer at a specific price within a specific time frame. For example, the current price of shares of ABC Company is $50 and you believe it will drop in 3 months. So you buy a put contract at $5 that gives you the right to SELL 100 shares of ABC shares for $50 in 3 months, even though you don’t physically have the shares, we will explain this later. 3 months later, the price falls to $40. You exercise the contract and sell 100 shares of ABC at $50. But because you don’t physically have the 100 shares, you need to borrow these shares to sell from somebody, for example a broker, and then return the shares to them later on. So you buy the 100 shares at $40 to return. Your net profit is ($50 x 100 shares) – ($40 x 100 shares) – ($5 contract cost) = $995.
The underlying concept behind call and put options really stems from the idea of LONG versus SHORT.
In the options market, we need both buyers and sellers of calls as well as buyers and sellers of puts for transactions to take place, supply and demand must exist for both. The group of people who buy options are called holders while those who sell are called writers.
Don’t sweat it if you find yourself confused at this point and time. In the next chapter, we will be going through more examples so that you can be more exposed to the concept of calls and puts, always remember, practice makes perfect!
How To Trade Options
Why Trade Options?
How Options Work
Types of Options Orders
Valuation of Options
Choosing The Best Options Broker
Leverage in Trading Options
Mistakes Options Traders Make