how options (calls & puts) work?

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Hello,

I’m hoping someone can explain how options work because it seems very confusing. I’ve been trying to wrap my head around it but there is a lot to wrap around. For example, how would a person make money off of selling puts? How do premiums work? Why is it better to buy a 30-day, $100 call option on a $95 stock than it is to buy a 30-day $96 call option? Would the buying it at $96 make for better profit? How does margin trading work and how does one increase their buying power using margin trading?

Thanks in advance for your help in understanding this topic.

In: Economics

2 Answers

Anonymous 0 Comments

>For example, how would a person make money off of selling puts?

You buy put options (which is a guarantee to sell a limited number of shares at a certain price, for a limited time.) Imagine you buy 100 $5 put options. The market price for the stock drops to $4. Even though the price is $4, you have a guarantee to be able to sell them at $5. So you buy 100 shares off the market for $400, and sell them for $500, making $100 minus the premium.

> How do premiums work?

The premium is simply the price of a option. Nobody’s going to give you a guarantee to buy things or sell things at a certain price for free. You have to pay for it. You might imagine you paid 50 cents each for the $5 puts, or $50 total since you bought 100 of them. Your total profit is $100-$50=$50.

The two most important factors in determining the premium is the volatility of the stock (since a more volatile stock is more likely to jump above the call price or below the put price) and the expiration time of an option (since a stock is more likely to go up or down in 2 years than 2 weeks)

It’s worth nothing that many entities which buy options do not intend to make profit from them. They buy them as insurance, to control risk. When an entity has call or put options, they have a guarantee that no matter what happens, they can buy or sell shares for a certain price.

> Why is it better to buy a 30-day, $100 call option on a $95 stock than it is to buy a 30-day $96 call option? Would the buying it at $96 make for better profit?

Simple. It might be better because the premium is cheaper. The $96 call option is obviously better if they were the same price. But they won’t be the same price.

Anonymous 0 Comments

Options are financial contracts that give the buyer the right (but not the obligation) to buy/sell an asset (such as stocks) at a guaranteed, fixed price in the future. However, the price of the asset must meet or exceed a threshold (the strike price) by the future date. Otherwise, the contract will expire worthless. Once bought, the options may also be sold to someone else.

> How do premiums work?

For covered calls/puts the seller of the contracts must either have the shares to sell (calls) or the money to buy (puts) 100 shares/contract to/from the buyer. Since the value of the underlying shares may go up or down in price up until the time of expiration, the seller charges a premium which represents the risk the seller takes when locking up their collateral plus the intrinsic value of the options (if any). If you think that the options you sell will all expire without being exercised, then you can generate income by collecting premiums.

> Why is it better to buy a 30-day, $100 call option on a $95 stock than it is to buy a 30-day $96 call option? Would the buying it at $96 make for better profit?

Since you stand to make a better profit buying a 30-day $96 call option than a 30-day $100 call option, the $96 call option would have a higher premium and thus be more expensive. And if the price were to go up to $99, then you’d be able to exercise the $96 call option, but the $100 call option would be useless.

>How does margin trading work and how does one increase their buying power using margin trading?

With margin trading, you put down money as collateral in order to borrow more money to buy stocks that you otherwise couldn’t. By doing this, you also take advantage of leverage. But your account balance must be above a certain value, otherwise you’ll be ordered to deposit more money into your account. If you don’t, then opened positions will be closed and your stocks will be automatically sold. Any debts remaining will be your responsibility.

Let’s say that you want to buy a $500,000 property because you think the value of that property will go up by 20% relatively soon.

Scenario 1: You buy the property for $500,000, the price goes up to $600,000, and you sell. You end up with an extra $100,000, which is a 20% profit on your original $500,000.

Scenario 2: You only have $100,000, so you go to the bank for a loan. The bank lends you $400,000 and you buy the $500,000 property. The price goes up to $600,000, and you sell. Then you pay back the $400,000 loan. You end up with an extra $100,000, which is a **100% profit** on your original $100,000.

In scenario 2, by taking out a loan, you were able to multiply your 20% gain 5x to 100%. This is called leverage. However, leverage also multiplies your losses. If the price of the property dropped by 25% instead, you would’ve lost $125,000 (a 25% loss in scenario 1, but a 125% loss in scenario 2! You would’ve lost your original $100,000 and still owe the bank an extra $25,000 in the 2nd scenario!)