If a random guy named Bob sells a put contract, then he is obliged to purchase 100 shares when the stock is below the strike at the expiration date. If Bob sells a call contract, then he will be obliged to sell 100 shares if the stock is above the strike at the expiration date. There are two main types of option contracts that the trader can choose from: American and European. All in all, options trading has come a long way in our day and age, and the option table is the living proof of this. As a quick review, a Call option contract gives us the right to buy 100 shares of the underlying security and is a nice tool to place a speculative long trade with tightly defined risk while tying up a small amount of trading capital. When you buy a call, this means you have the chance to buy a stock at the strike price before it expires.
The majority of traders will close their option prior to the expiration date in order to limit losses or to receive profits earlier.
Furthermore, if Bob buys a call contract, he then has the option to buy 100 shares at the strike price.
Now that you know how this terminology works, you are prepared to read the table and use it to develop your own option trading strategy. It is profitable to do so if the stock’s price is above the strike so that he could buy the shares for less than the stock is trading. The difference is that American options can be exercised before the expiration date, unlike European options.
A Put is similar in structure to a Call, but is the right to sell 100 shares of the underlying security at a set strike price.
From this point of view, American options are more advantageous, especially for the inexperienced trader. Since a Put increases in value as the underlying drops in value it can be used as a vehicle to protect portfolio positions in case of a downturn as well as for a speculative short directional trade in a security.CMG Case StudyLet’s take a look at using Puts to hedge and protect gains for your account. An ideal solution is to sell ? of the shares to recover most of the original principal and use a portion of the profits to purchase a CMG Put option to lock in gains on the remainder.
A protective put creates a loss protecting floor at the strike price minus the cost of the put.
Let’s examine the results comparing an in the money 400 strike put with an at the money 380 strike put.
From the previous article we remember that in the money options have a higher delta which means they are more sensitive to changes in the stock price. Because no matter how far the CMG stock trades under the strike price, you would still have a right to exercise the option and sell your shares at the strike. If you felt that CMG had found price support here at the $300 level and was done with its correction, you could sell your put to close the initial option position and buy a lower strike put farther out in the calendar (i.e. The net profits going forward from continued CMG appreciation would be greater since you had taken a bunch of option premium off the table and switched from a very deep in the money to an at the money put. Just be careful not to roll until you definitely have seen signs of price support and better odds of a sustained reversal higher.Profit from Stock Drop Using Speculative PutThe opportunity to buy a put option without owning CMG shares could have been used for a speculative directional trade in order to profit from an anticipated drop in CMG. Compare that to an attempt to short sell CMG stock where there could be unlimited losses and a great deal of trading capital tied up.
If you use puts to make defined risk directional short trades, stay small, be sure to calculate your breakeven point (Strike Price – Put Premium) and be very aware of the time value or Theta decay that reduces the price of the put and erodes your potential profit.In upcoming articles, we’ll explore more option portfolio protection strategies – writing covered calls, creating option collars, and introducing option spread trades. All will be fairly straight forward given that you already understand the Call and Put basic fundamentals that we’ve presented in this article and the previous one.
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