The most attractive characteristic of owning call options is that your profit is technically unlimited.
Since owning options is always cheaper than owning the stock itself, when you KNOW a stock price is about to move up it is ALWAYS more profitable to own calls on the stock than it is to own the stock itself! Since call options give the owner the right to buy a stock at a fixed price, owning calls allows you to lock in a maximum purchase price for a stock.
Calls trade on an exchange (The Chicago Board of Options Exchange--CBOE), just like stocks do. That sounds great, but watch how buying a call option on YHOO would have given you a 400% return (instead of the 25% return from buying the stock!
Options were originally traded in the over-the-counter (OTC) market, where the terms of the contract were negotiated. The Exercise of Options by Option Holders and the Assignment to Fulfill the Contract to Option WritersWhen an option holder wants to exercise his option, he must notify his broker of the exercise, and if it is the last trading day for the option, the broker must be notified before the exercise cut-off time, which will probably be earlier than on trading days before the last day, and the cut-off time may be different for different option classes or for index options.
When the assigned option writer must deliver stock, she can deliver stock already owned, buy it on the market for delivery, or ask her broker to go short on the stock and deliver the borrowed shares. An alternative method for buying a shorter term option is to buy only deep ITM options. An option is a standardized contract providing for the right - but not the obligation - to buy or sell an underlying financial instrument. In exchange for the right to buy ("call") or sell ("put") an underlying security on or before the expiration date, the purchaser of an option pays a premium. The strike price, or exercise price, of an option determines whether that contract is in the money, at the money, or out of the money.
Intrinsic value describes the amount the stock price is above the strike price (for calls), or below the strike price (for puts). If the stock were at 500 when you bought a 510 call, the option is again all time value, since it has to rise $10 to be in the money. Again using Google for an example, the GOOG December 500 call option gives you the right to buy 100 shares of GOOG for $500 per share up until the expiration date in December. Let's say you purchased the GOOG 500 call option for $25 when the stock was trading for $500. The flip side is that if the stock does not move up, then the option will lose all of its value by expiration. Letting it expire - If a call gets all the way to expiration, it will expire worthless if it is out-of the money (when the strike price is above the stock price). In this case, let's say you were concerned about the downside, so you purchased the GOOG 500 put option for $25 when GOOG the stock was trading for $500.
Letting it expire - If a put gets all the way to expiration, it will expire, worthless if it is out of the money (when the stock price is above the strike price - See Options Pricing).
Regardless of whether you are buying calls or puts, there are some general rules to follow. Two, options should generally be bought when the time value - primarily influenced by a factor known as implied volatility, or the expected price swings of the underlying - is expected to stay flat or to rise. Finally, when you buy an option, generally you will want to sell it, ideally for a still-greater premium. By way of explanation, let's say you sold the GOOG 500 call option for $25 when GOOG was trading for $500. Because of this unlimited risk as the underlying stock price rises, selling calls is rarely done in isolation. Letting it expire -If the option gets all the way to expiration, it will expire, worthless if it is out of the money. Assignment - American-style options (all equity and ETF options) can be exercised at any time before expiration. Selling options is best done when implied volatilities, and therefore option premiums, are high and expected to fall. Since we already know that time decay is greatest in the last 30 to 45 days, this is typically the best time to sell options. Example: Apple (AAPL) is trading for 175, a price you like, and you sell an at-the-money put for $9. Example: You own 100 shares of AAPL at 190 and want to protect your position, so you buy a 175 put for $1. The process in which the buyer of an option takes, or makes, delivery of the underlying contract.
The process by which the seller of an option is notified that the contract has been exercised. In consideration of your time, we'll send the first two chapters of Jon and Pete's latest book, How We Trade Options. A call option is a financial derivative that gives the holder the right (but not the obligation) to buy the underlying stock at a pre-specified price (the strike price) at any time up to the day when the option expires (the expiration date). In the example payoff above, the call pays nothing up to the strike price at 15, after which the option is in the money and will increase in value as the underlying stock continues to advance.
The long call option is considered to be limited risk, because you can only lose the full amount of what you put in. A Short Call Options, also known as Naked Call Options strategy, involves the sale of a call option. Let the option expire worthless and earn the full sum of premium collected Buy back the call options and close off the position at a profit.Buy a lower strike call of the same expiration date and create a Bear Call Spread Strategy. Trading call options is so much more profitable than just trading stocks, and it's a lot easier than most people think, so let's look at a simple call option trading example.
While a 25% return is a fantastic return on any stock trade, keep reading and find out how trading call options on YHOO could give a 400% return on a similar investment! With call option trading, extraordinary returns are possible when you know for sure that a stock price will move a lot in a short period of time. To make things easy to understand, let's assume that this call option was priced at $2.00 per share, which would cost $200 per contract since each option contract covers 100 shares.
When YHOO goes to $50, our call option to buy YHOO at a strike price of $40 will be priced at least $10 or $1,000 per contract. So when trading the YHOO $40 call, we paid $200 for the contract and sold it at $1,000 for a $800 profit on a $200 investment--that's a 400% return. Call and Put Option Trading Tip: Finally, note from the graph below that the main advantage that call options have over put options is that the profit potential is unlimited! If the price of YHOO rises above $40 by the expiration date, to say $45, then your call options are still "in-the-money" by $5 and you can exercise your option and buy 100 shares of YHOO at $40 and immediately sell them at the market price of $45 for a $3 profit per share.
Now if YHOO stays basically the same and hovers around $40 for the next few weeks, then the option will be "at-the-money" and will eventually expire worthless.
Now on the other hand, if the market price of YHOO is $35, then you have no reason to exercise your call option and buy 100 shares at $40 share for an immediate $5 loss per share.
Also note that call options that are set to expire in 1 year or more in the future are called LEAPs and can be a more cost effective way to investing in your favorite stocks. Always remember that in order for you to buy this YHOO October 40 call option, there has to be someone that is willing to sell you that call option.
The second thing you must remember is that a "call option" gives you the right to buy a stock at a certain price by a certain date; and a "put option" gives you the right to sell a stock at a certain price by a certain date. As Foreign Exchange (Forex) markets comprise the largest volume of monetary values traded on a daily basis when compared to every other financial market and asset class, it is no coincidence that one such popular method of trading currencies include forex options trading – also known as currency trading options. An option is a right but not an obligation to buy or sell an underlying asset class at a specified strike-price, and the right of which can be bought or sold either on an exchange (exchange-traded) or in the over-the-counter (OTC) markets (off-exchange). The owner of an option contract can exercise this right to buy or sell, up until expiration of the contract at which point the option expires worthless if not exercised.
Although the share of forex options trading overall doesn’t dominate the majority of FX market volumes, it still represents a meaningful share of trading and thus can be a viable instrument and method to consider when investing or trading foreign exchange. Just like options on nearly any financial instrument, in foreign exchange, call options involve the right to buy – and put options convey the right to sell -an underlying instrument at a specified exchange rate, and premiums are paid by buyers and earned by sellers when carrying out forex options trading. Options contract are typically for a pre-determined quantity of an underlying asset, and will vary depending on the contract specifications of the broker or exchange operator, as well as the specific instrument being traded, such as an underlying currency pair. Options are divided into Puts and Calls, whereas a “Call” is the right to buy an underlying asset at a specified strike-price, and where a “Put” is the right to sell an underlying asset at a specified strike-price.
However, Buying or Selling either of these option types can have very different consequences.
Moreover, each option contract conveys a quantity of the underlying asset that will be traded if the contract is exercised by the party that has the right to exercise their option. In the event the buyer of this option exercised the contract, the seller would technically need to deliver the underlying EUROS in exchange for the US Dollars the seller was paying to purchase the 100,000 Euros at the underlying strike price. If we go with the false assumption that the stock market will return on average 8% a year, doing a covered call that returns 1% a month will beat the market and do 12% a year.
The covered call trade strategy (aka buy-write) involves buying the stock and selling one call option against every one hundred shares that is owned.
If we were to buy 100 shares of stock in Microsoft, Ticker MSFT for $25.80 a share and then sell the $26 call. Another negative to the covered call trade is when a call is sold and then the stock far surpasses the strike price and now the profit was limited. When you are creating a covered call trade, it can be done at one time by placing a combination trade.
That "certain price" is called the strike price, and that "certain date" is called the expiration date.
It is also called an "option" because the owner has the "right", but not the "obligation", to buy the stock at the strike price.
This shows that Microsoft (MSFT) is at $25.81 and that the April options expire on April 16, 2011 and that the strike prices for the call and put range from at least $23 to $28 and are at every dollar in between. It is a maximum purchase price because if the market price is lower than your strike price, then you would buy the stock at the lower market price and not at the higher exercise price of your option. Like all securities, all calls and puts have a unique ticker symbol and their prices are determined by the market's buyers and sellers.
The advantage of the OTC market over the exchanges is that the option contracts can be tailored: strike prices, expiration dates, and the number of shares can be specified to meet the needs of the option buyer. Although policies differ among brokerages, it is the duty of the option holder to notify his broker to exercise the option before the cut-off time.When the broker is notified, then the exercise instructions are sent to the OCC, which then assigns the exercise to one of its Clearing Members who are short in the same option series as is being exercised. However, finding borrowed shares to short may not always be possible, so this method may not be available.If the assigned call writer buys the stock in the market for delivery, the writer only needs the cash in his brokerage account to pay for the difference between what the stock cost and the strike price of the call, since the writer will immediately receive cash from the call holder for the strike price.
Buying deep ITM option is more expensive but the attraction is that it is straight forward and almost can have point for point price movement of the underlying stock.
If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in the money because the holder of the call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the market.
If GOOG were trading at $500 when you bought a 490 strike call option for $25, then $10 of the option's value would be intrinsic value. Buying calls gives you leverage over 100 shares of an underlying stock (or ETF) at the strike price until the expiration date.
You would do this with the expectation that the price of the option will rise, usually through the rise in the price of the underlying stock. This is the most common way of exiting a long position, and the only way of exiting a long call that captures any remaining time value in the option. This is the only way of exiting a long position that captures any remaining time value in the option. One, the expiration should give the option enough time to perform without being overexposed to time decay. Buying options is a limited-risk strategy, and all of that risk lies in the premium paid for the option. When option premiums are high (that is, when implied volatility is high), some traders turn to selling options. By selling calls, you are obligating yourself to selling the stock at the strike price when you are assigned. This is the reason that brokerages require a margin account for individuals who wish to sell naked calls. Here we the ideal is to have the options expire worthless, and we are not interested in buying back the options we have sold unless necessary. INTC moves up to $28 and so your option gains at least $2 in value, giving you a 200% gain versus a 12% increase in the stock.
Option chains show data for a given underlying's different strike prices and expiration months. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OptionsHouse.
If the stock goes up to $1,000 per share then these YHOO $40 call options would be in the money $960!
If YHOO stays at $40 then the $40 call option is worthless because no one would pay any money for the option if you could just buy the YHOO stock at $40 in the open market.
That's where your call option comes in handy since you do not have the obligation to buy these shares at that price - you simply do nothing, and let the option expire worthless. That is why the line in the call option payoff diagram above is flat if the closing price is at or below the strike price.
People buy stocks and call options believing their market price will increase, while sellers believe (just as strongly) that the price will decline. You can remember the difference easily by thinking a "call option" allows you to call the stock away from someone, and a "put option" allows you to put the stock (sell it) to someone.
In addition, as will be revealed below, sellers of options, known as writing options, carries its own set of differences when compared to buying options, and understanding currency trading options can be a valuable tool in a forex trader’s portfolio. The way that such measurements are made depends also on what type of option position is being taken, whether a Call is being bought or sold, or whether a Put is being bought or sold, as will be described below. For example, buying a call gives the buyer the right to buy at the underlying strike-price of the option, whereas selling a call requires that the seller must be able to deliver the underlying asset and sell it to the buyer at the underlying strike-price if the buyer decides to exercise their option prior to expiration. Take a look at Microsoft stock ticker $MSFT as an example of buying and selling a covered call. The call option also gives the seller the obligation to sell the buyer the stock for the predetermined price.
In other words, the owner of the option (also known as "long a call") does not have to exercise the option and buy the stock--if buying the stock at the strike price is unprofitable, the owner of the call can just let the option expire worthless. It is called "a call option" because it allows you to "call" the stock away from somebody (ie, buy it). However, transaction costs are greater and liquidity is less.Option trading really took off when the first listed option exchange—the Chicago Board Options Exchange (CBOE)—was organized in 1973 to trade standardized contracts, greatly increasing the market and liquidity of options.
The Clearing Member will then assign the exercise to one of its customers who is short in the option.
Similarly, if the writer is using margin, then the margin requirements apply only to the difference between the purchase price and the strike price of the option.
A Long Call usually increases in value due to the rise in the underlying stock price or increase in volatility.
Buying OTM option is cheaper and offers you higher leverage but it is also a low-probability strategy. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in the money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive in the market. Therefore an at-the money or out-of-the-money option has no intrinsic value and only time value.
This gives you a 100 percent return on the call option based on a 10 percent return on the stock.
Long calls are almost always sold before expiring, since at that point they will have lost all time value. Long options are almost always sold before expiring, as at that point they will have lost all time value.
Since options have an expiration date, a large part of their value is time value (for more, see our lesson on Options Pricing). All else equal, if there is a rise in implied volatility, then there will be a rise in the option premiums. It is also the reason that selling calls is considered the options strategy with the highest risk. Another way to buy stock for less than the current market price is an options strategy called cash-secured puts. For instance, if you sold a call, the stock went up through your strike, and you do not want to be assigned and forced to sell the stock, you could buy back the option to close the position. If it is in the money by $.01, it will be automatically exercised and you will be assigned, automatically selling stock if you were short a call or buying stock if you were short a put.
It is important to remember, however, that selling options involves considerable risk, and high implied volatility can always go higher. If the stock is still at 34 at expiration, the option will expire worthless, and you made a 3% return on your holdings in a flat market. This should not be considered a solicitation to open an OptionsHouse account or to trade with OptionsHouse. OptionsHouse does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. Trading or buying one call option on YHOO now gives you the right, but not the obligation, to buy 100 shares of YHOO at $40 per share anytime between now and the 3rd Friday in the expiration month. Since all option contracts cover 100 shares, your real profit on that one call option contract is actually $300 ($5 x 100 shares - $200 cost). When this happens, your options are considered "out-of-the-money" and you have lost the $200 that you paid for your call option.
If we sell the $26 call and on options expiration day Microsoft stock is still below $26 a share we get to keep the $50 from selling the call and the stock stays in our account. Sometimes people will sell the call that expires in this month and then the stock has an earnings announcement and the volatility of the option drops giving them a profit on the far out of the money call that they sold.
This diagram shows the payoff for owning call options with a strike price of $40 and a cost of $2. The CBOE was the original exchange for options, but, by 2003, it has been superseded in size by the electronic International Securities Exchange (ISE), based in New York. You should pick the strike price and time frame of the call options according to your risk profile and forecast.
The higher the implied volatility, the more expectation that the underlying stock will make big moves, increasing the option's chances of being in the money. This time value will deteriorate as that expiration approaches; time decay increases exponentially in the last 30 to 45 days of an options life, so this is usually not the time to own options. This increase can produce profits for long options, even if the stock price doesn't move, because the chance of movement has increased. You want the market price to be below the strike of the call you sold, so that it expires worthless. If a call buyer decides to exercise the long call, that exercise is put out randomly to a seller -any seller - of that call, and the individual is obligated to sell stock to the call buyer.
In contrast, European style call options only allow you to exercise the call option on the expiration date!
You will notice that if the stock price closes at or below $40, you lose the $200 ($2 price times 100 shares) cost of buying the option (note the horizontal line intersecting the y-axis at -$200). Thus, there is no direct connection between an option writer and a buyer.To ensure contract performance, option writers are required to post margin, the amount depending on how much the option is in the money. If the strike price equals the current market price, the option is said to be at the money. Conversely, if you buy options when implied volatility and premiums are high, such as before earnings, then the stock can move in the direction that you want and you can still lose money, because with the news out, the implied volatility could fall. The seller has received a "premium" in the form of the initial option cost the buyer paid ($2 per share or $200 per contract in our example), earning some compensation for selling you the right to "call" the stock away from him if the stock price closes above the strike price. If the margin is deemed insufficient, then the option writer will be subjected to a margin call. Finally, notice that the up sloping line become profitable at $42, which is the strike price of $40 plus the $2 cost of buying the option. Option holders don’t need to post margin because they will only exercise the option if it is in the money. I do not expect on what to trade.I just want to learn how to properly trade options Both calls and puts and what is in between.
Theoretically the stock price can go to infinity so that is why they say the earnings from owning a call option are unlimited. However, to trade options, an investor must have a brokerage account and be approved for trading options and must also receive a copy of the booklet Characteristics and Risks of Standardized Options.The option holder, unlike the holder of the underlying stock, has no voting rights in the corporation, and is not entitled to any dividends.
It is for largely that reason that most retail options traders underestimate the challenge of making money with options. Brokerage commissions, which are a little higher for options than for stocks, must also be paid to buy or sell options, and for the exercise and assignment of option contracts. The OCC buys the contract, adding it to the millions of other option contracts in its pool. Sarah Call-Buyer buys a contract that has the same terms that John Call-Writer wrote—in other words, it belongs to the same option series. The OCC issues, guarantees, and clears all option trades involving its member firms, which includes all U.S. Sarah buys from the OCC, just as John sold to the OCC, and she just gets a contract giving her the right to buy 100 shares of Microsoft for $30 per share until April, 2007.Scenario 1—Exercises of Options are Assigned According to Specific ProceduresIn February, the price of Microsoft rises to $35, and Sarah thinks it might go higher in the long run, but since March and April generally are volatile times for most stocks, she decides to exercise her call (sometimes referred to as calling the stock) to buy Microsoft stock at $30 per share to be able to hold the stock indefinitely. Although the buying and selling of options is settled in 1 business day after the trade, settlement for an exercise or assignment occurs on the 3rd business day after the exercise or assignment (T+3), since it involves the purchase of the underlying stock.Often, a writer will want to cover his short by buying the written option back on the open market. The OCC is jointly owned by its member firms — the exchanges that trade options — and issues all listed options, and controls and effects all exercises and assignments. To provide a liquid market, the OCC guarantees all trades by acting as the other party to all purchases and sales of options.The OCC, like other clearing companies, is the direct participant in every purchase and sale of an option contract.
When an option writer or holder sells his contracts to someone else, the OCC serves as an intermediary in the transaction.
This is the risk that an option writer has to take—an option writer never knows when he'll be assigned an exercise when the option is in the money.Scenario 2—Closing Out an Option Position by Buying Back the ContractJohn Call-Writer decides that Microsoft might climb higher in the coming months, and so decides to close out his short position by buying a call contract with the same terms that he wrote—one that is in the same option series. Sarah, on the other hand, decides to maintain her long position by keeping her call contract until April.
A customer may not want to exercise an option that is only slightly in the money if the transaction costs would be greater than the net from the exercise. Under its SEC jurisdiction, OCC clears transactions for put and call options on common stocks and other equity issues, stock indexes, foreign currencies, interest rate composites and single-stock futures.
In spite of the automatic exercise by the OCC, the option holder should notify his broker by the exercise cut-off time, which may be before the end of the trading day, of an intention to exercise. As a registered Derivatives Clearing Organization (DCO) under CFTC jurisdiction, the OCC clears and settles transactions in futures and options on futures. John closes his short position by buying the call back from the OCC at the current market price, which may be higher or lower than what he paid, resulting in either a profit or a loss. Exact procedures will depend on the broker.Any option that is sold on the last trading day before expiration would likely be bought by a market maker.
Because a market maker’s transaction costs are lower than for retail customers, a market maker may exercise an option even if it is only a few cents in the money. Thus, any option writer who does not want to be assigned should close out his position before expiration day if there is any chance that it will be in the money even by a few pennies.Early ExerciseSometimes, an option will be exercised before its expiration day—called early exercise, or premature exercise. Because options have a time value in addition to intrinsic value, most options are not exercised early.
However, there is nothing to prevent someone from exercising an option, even if it is not profitable to do so, and sometimes it does occur, which is why anyone who is short an option should expect the possibility of being assigned early.When an option is trading below parity (below its intrinsic value), then arbitrageurs can take advantage of the discount to profit from the difference, because their transaction costs are very low. An option with a high intrinsic value will have very little time value, and so, because of the difference between supply and demand in the market at any given moment, the option could be trading for less than its true worth. Anyone who is short an option with a high intrinsic value should expect a good possibility of being assigned an exercise.Example—Early Exercise by Arbitrageurs Profiting from an Option DiscountXYZ stock is currently at $40 per share.
This causes many call holders to either exercise early to collect the dividend, or to sell the call before the drop in stock price. When many call holders sell at the same time, it causes the call to sell at a discount to the underlying, thereby creating opportunities for arbitrageurs to profit from the price difference.
Adding the $1 dividend to the share price yields $40, which is still less than buying the stock for $30 plus $10.20 for the call. Option writers have lost at least something when the option is exercised, because the option holder wouldn't exercise it unless it was in the money. The more the exercised option was in the money, the greater the loss is for the assigned option writer and the greater the profits for the option holder.
A closed out transaction could be at a profit or a loss for both holders and writers of options, but closing out a transaction is usually done either to maximize profits or to minimize losses, based on expected changes in the price of the underlying security until expiration.
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