Understanding Puts and Calls

Module 1: Option Basics
Lesson 5: Puts and Calls

Puts and Calls are the only two types of stock option contracts. They are the key to understanding stock options. You can use them to make money in any market environment.

I know from experience that understanding stock options is hard.

There is just so much information to take in. That is why I'm not teaching you any advance strategies.

My focus is on the basics.

2 types of stock option contracts: Puts and Calls

Every options trading strategy involves only a Call, only a Put, or a variation or combination of these two.

Puts and Calls are often called wasting assets. They are called this because they have expiration dates. Stock option contracts are like most contracts, they are only valid for a set period of time.

So if it's January and you buy a May Call option, that option is only good for five months. The contract will expire or cease to exist in May, and when it expires so do all the rights the contract granted you.

Technically speaking, Puts and Calls expire the 3^rd Saturday of the month of expiration. For example if I bought a December option, it will cease to exist (expire worthless) after the 3^rd Saturday of December.

However, stock option contracts cannot be traded on Saturday so for trading and practical purpose we say that stock option contracts expire on the 3^rd Friday of the month of expiration.

A quick recap from the previous lessons:

• Buying Put options gives you the right to sell a stock
• Buying Call options gives you the right to buy a stock

These stock option contracts are commonly referred to as Puts and Calls.

Options trading (the buying side) is merely buying contracts that you think will increase in value. Once they do increase in value you sell them at a higher price and pocket the difference.

In "most" cases you never intend on exercising your rights to purchase, or sell, the stock. You just want to benefit from the movement of the stock without having to own the stock and you can do this with Puts and Calls.

Here's how...

Puts and Calls in Action
Profiting When a Stock Goes
Down in Value

Buying Put options gives the buyer the right, but not the obligation, to sell shares of a stock at a specified price on or before a given date.

A "Put option" increases in value when the underlying stock it's attached to declines in price, and decreases in value when the stock goes up in price.

That one is worth reading again. When you're first learning it's always hard to wrap your head around that concept. Once we break down how Puts and Calls work it should be easier to understand the above concept.

Remember Put options give you the right to sell a stock at a specified price. When you are buying Put options, you are expecting, or want, the price of the stock to decline.

For instance if you bought an IBM December 130 "Put option", the option (contract) gives you the right to "sell" IBM stock for a price of $130 on or before the third Friday of December.

If IBM falls below $130 before the 3^rd Friday in December you have the right to sell the stock for more than its market value.

So let's say that IBM falls in price to $76. Everyone else who owns the stock has to sell it for $76, but you own a contract that says you can sell it for $130!

Now can you see why Put option contracts go up in value as the underlying stock goes down in price? The further the stock falls in price below your strike price ($130) the more valuable the option becomes.

You hold a contract that says you get to sell something for more than its market value.

Someone who owns a great deal of that stock and is facing the pressure of selling it at $76 would love to own a contract that says they could sell it for $130. And do you think they might be willing to buy that contract from you? Yup they sure would.

Let's say IBM was trading at $200 a share. Who would want to buy a contract from you that gives them the right to sell it for $130 a share when they could easily sell it for $200 on the open market?

No one, which is why Put options decrease in value as the stock price goes up.

Puts and Calls in Action
Profiting When a Stock Goes
Up in Value

**Tip** The easiest way of understanding stock option contracts is to realize that Puts and Calls function opposite of each other.

Buying Call options gives the buyer the right, but not the obligation, to buy shares of a stock at a specified price on or before a given date.

"Call options" increase in value when the underlying stock it's attached to goes up in price, and decrease in value when the stock goes down in price.

Call options give you the right to buy a stock at a specified price. You buy a Call option when you think the price of the underlying stock is going to go up.

In the example above let's say you bought an IBM December 95 "Call option" instead. This option gives you the right to "buy" IBM stock for $95 on or before the 3^rd Friday of December.

Now imagine that IBM comes out with a new product and the stock shoots up in price to $127. You own a contract (Call option) that says you can purchase it for $95 a share.

Think shopping, you get to buy it at a ($32) discount or sales price when everyone else has to pay the full retail price.

So as the stock goes up in price, the 95 Call option goes up in value. A $140 stock price means you get a $45 discount in price etc. etc.

That's the equivalent of someone trying to sell you a car for $2000 when the blue book value of it is $1500.

Lesson Review

Most Puts and Calls are never exercised. Option Traders buy and resell stock option contracts before they ever hit the expiration date.

This is because minor fluctuations in the price of the stock can have a major impact on the price of an option. So if the value of an option increases sufficiently, it often makes sense to sell it for a quick profit.

If you have followed the lessons step by step and are confused, then I highly recommend you go back through Module 1 until you have a good grasp of the concepts.

Confusion on top of confusion just equals more confusion. Take the time to learn it right the first time; it will be well worth your time, because fully understanding stock options is key to consistent profits.

For a quick review of all the lessons in Module 1 read the Option Basics Review.

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