How to Trade Puts and Calls

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"Have you ever wanted to know how to trade puts and calls?"

Have you ever wanted to know how to trade puts and calls? Do you know what a put or a call is? Trading Puts and Calls can be very lucrative; for all of you out there wondering what they are, and how to trade them, read on.

What Is a Put?

An option contract giving the owner the right, but not the obligation, to sell a specified amount of an underlying asset at a set price within a specified time. The buyer of a put option estimates that the underlying asset will drop below the exercise price before the expiration date.

When an individual purchases a put, they expect the underlying asset will decline in price. They would then profit by either selling the put options at a profit, or by exercising the option. If an individual writes a put contract, they are estimating the stock will not decline below the exercise price, and will not fall significantly below the exercise price.

Consider if an investor purchased one put option contract for 100 shares of ABC Co. for $1, or $100 ($1*100). The exercise price of the shares is $10 and the current ABC share price is $12. This contract has given the investor the right, but not the obligation, to sell shares of ABC at $10.

If ABC shares drop to $8, the investor's put option is in the money and he can close his option position by selling his contract on the open market. On the other hand, he can purchase 100 shares of ABC at the existing market price of $8, and then exercise his contract to sell the shares for $10. Excluding commissions, his total profit for this position would be $100 [100*($10 - $8 - $1)]. If the investor already owned 100 shares of ABC, this is called a "married put" position and serves as a hedge against a decline in share price.

What Is a call?

A Call is an options contract that gives the buyer the right to exercise the option and buy the underlying commodity at the strike price on (European-style options) or at any time up to (US style options) the expiration date.

An options trader can be long a Call, in which case they have bought a Call contract, and have the right of exercise described above. Or a trader can be short a Call, in which case they have sold a Call contract, and may be required to sell the underlying commodity if they are chosen by the exchange (or options clearing system) to complete their contract obligations.

Options are classified as derivative contracts that are tied to an underlying asset, such as a stock, bond or futures contract. Call options give the buyer the right but not the obligation to buy a certain asset at a certain price; put options give the buyer the right but not the obligation to sell a certain asset at a certain price. For this reason, they are often used as insurance protection against open positions in one's portfolio.

In addition to the risk protection they offer, options are often traded as an individual asset class by traders looking to take advantage of the leverage and extreme price moves they offer. It is not unusual for certain options contracts to double or even triple in one day, or for that matter, to go down by 50% in one day. It takes only a small percentage move in the underlying stock, bond or futures contract to create a sizeable move in the option contract.

How to Trade Puts and Calls
  • Find a broker. The first step to trading options is to find a broker who will give you access to the market. The easiest and cheapest way to do this is online through one of the many online discount brokerage houses.

  • Do your research. Put options give you the right to sell a stock at a certain price, and call options give you the right to purchase a stock at a certain price. Puts can be used to protect open long positions or profit from a downward move in the price of underlying asset, while calls can be used to protect open short positions or to profit from a move higher in the price of the underlying asset. Know what you are buying before you make the purchase.

  • Understand the cost of what you are buying. Stock options trade with a multiple of 100. This means that if an option is priced at $2, buying one contract means you have purchased a right to either buy or sell 100 shares of the stock, and so the cost basis of this contract will be $200.

  • Use your software. Options are priced based on rather esoteric mathematical formulas. Good trading software will provide clients with an options pricer that calculates what the price of an option should be based on certain conditions. Be sure to utilize this feature when deciding the price at which to buy or sell an option.

  • Remember volatility pricing. Options can be priced in volatility as well as dollars. The volatility reflects the overall desire in the market to purchase the option, so a higher volatility will mean a higher price. It is important to take into consideration both price and volatility when valuing an option.

  • Sell options when the timing is right. When volatility is high, it is often a better idea to sell a call rather than buy a put. This way, you profit from a decrease in volatility as well as a fall in the price of the option. Just remember, selling a call is like shorting a stock: the potential loss is theoretically limitless.

  • Never sell a put. While it is ok to sell calls in certain situations, it is never a good idea to sell a naked or unprotected put. In the event of a market crash, being short a put would be disastrous.
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