We are seeing an increase in options trading with our clients, so I am going to briefly explain the basic trades of traded stock options (American style (used in Canada also)).

An option is a contract which gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified strike price on or before a specified date. The seller has the corresponding obligation to fulfill the transaction, to sell or buy the underlying asset if the option is exercised.

Options trading is not for everyone, you must thoroughly understand what you are doing and consider several strategies with your options broker before entering into this market.

Long Call (Buying a Call)

A trader who believes a company’s stock price will increase might buy the right to purchase the stock at a fixed price (the premium), rather than purchasing the stock itself.  There is no obligation to buy the stock, only the right to do so until the expiry date.

If the stock price at expiration is above the exercise price by more than the premium paid, the deal  is profitable.

If the stock price on the expiration date is lower than the exercise price, the option would not be exercised and the buyer would only lose the amount of the premium.

Long Put (Buying a Put)

A trader who believes that a stock’s price will decrease can buy the right to sell the stock at a fix price for a specified period of time.  He will be under no obligation to sell the stock, but has the right to do so until the expiration date.

If the stock price at expiration is below the exercise price by more than the premium paid, the deal is profitable.

If the stock price at expiration is above the exercise price, the option would not be exercised and the loss would be the amount of the premium paid.

Short Call (Selling a Call)

A trader who believes that a stock price will decrease can sell a stock short or instead sell, or “write” a call.  The trader selling a call has an obligation to sell the stock to the call buyer, at the buyer’s discretion   anytime before the option expires.

If the stock price decreases, the short call will make a profit in the amount of the premium

If the stock price increases over the exercise price by more than the premium amount, the short will lose money, with the potential loss unlimited.

Short Put (Selling a Put)

A trader who believes a stock price will increase can buy the stock or instead sell, or “write” a put.  The trader selling a put has an obligation to buy the stock from the put buyer, at the buyer’s discretion  anytime before the option expires.

If the stock price at expiration is above the exercise price, the short put position will make a profit in the amount of the premium.

If the stock price at expiration is below the exercise price by more than the amount of the premium, the trader will lose money, with the potential loss being up to the full value of the stock.

Here are some links to explore options trading in more detail:

Options FAQ courtesy of TMX Montreal Exchange

Options Basics Tutorial courtesy of Investopedia.com

Option (Finance) courtesy of Wikipedia

Chicago Board Options Exchange

Call Options (What are Put Options)

Put Options (What are Call Options)

The Options Guide

Disclaimer:

This information is provided as an information service only and is not intended to substitute for competent professional advice. No action should be initiated without consulting a professional advisor.

 

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