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Options and Calls

7/16/2016

We’ve learned about stocks, so now let’s transition to options!

What’s an option?
An option is a type of derivative that gives the buyer of the option the right to buy or sell one hundred shares of stock at a given price (known as the strike) for a given amount of time until expiration. In layman’s terms, it is in sorts a hedge that buyer/seller is insured against price fluctuations in the market for a certain amount of time.

Why is an option a derivative?
Most liquid stocks have a corresponding option contract. The price of the option is primarily driven or derived by the price of the stock, but other factors like strike price, time duration, implied volatility, and prevailing interest rates, for example, play a significant role in deciding the theoretical price determination of an option.

What do I do with an option?
Well, there are many options. (Pun intended) There are two types of options: call options and put options. Just as you can buy and sell stocks, you can buy and sell options. These operations can be combined, and will be discussed in future strategies, but for today let’s break down the mechanics of buying a call option.

Buying calls:

By buying a call option, the buyer can purchase units of stock at the set strike price, when the current market value of the stock is greater than the strike price at or before expiration.

What does this mean?

When buying or selling any option there are three key elements: premiums, strike prices, and expirations. When buying a call option the buyer must pay a premium, or a small fee, to the seller. This validates the options agreement between the two parties of the options contract. The buyer sets both a strike price and expiration, and is matched with a seller in the market who has set the same values for his/her transaction. The strike price, in the in the instance of the buying a call, is the maximum amount of money the buyer is willing to spend when purchasing units of stock. The expiration date, set by the buyer, is the period in which the contractual agreement between the buyer and the seller is upheld.

By paying a premium fee to the seller, the buyer of the call may buy the units of stock from the seller, if the price of the stock reaches or exceeds the set strike price within the time period/before expiration.

The probability of success with options is determined by the movement of the stock. For buying calls, if the stock's price...

Increases to strike price + option premium= You break even! OR Increases above break even price= You profit!
Stays the same= The time value, or theta, of the option's premium decays over the passage of time. As the contract approaches expiration, the time value portion of the stock decreases. This is a not beneficial to the buyer of the call option.
Decreases below the original price= The buyer of the call incurs the loss of the decaying option price as well as the premium paid for the option.

In summary, a buyer of a call option is profitable in 1/3 cases, causing them to have a 2/3 chance of losing, as the stock could either stay the same or go down. On the bright side, the max loss the buyer will incur is the premium paid for the call option.

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Introduction to Stocks

7/13/2016

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What is a stock?
A unit of stock represents ownership in a company that can be bought or sold in the market. After opening up a brokerage account, you are ready to trade!

What do I do?
To start off, let’s explore buying and selling stocks, or having a long or short (respectively) position.

Going long: Buy-low, sell-high
When you are going long on a stock, you buy the stock at a low price and sell it to someone else in the market at a high price. Imagine you are not a trader, but rather a shop owner, and you are not selling stocks, but you are selling books, for example. You buy your “books” at a low price, so that when you sell them to your customers you can charge or sell your books for a higher price and make a profit. The same logic applies when going long on a stock: buy at a low price and sell at a high price to make a profit! When you are going long you are under the assumption that the stock’s price will rise in the future.

Shorting stock: Sell-high, buy-low
When you are shorting a stock, you open a sell position at a high price and fufill your obligation of buying back the stock at a low price. It seems illogical, selling before buying, but the market is a mysterious place. When you short a stock, you are acting opposite of how you would approach a long position. You sell high and buy low, under the assumption that the stock’s price will fall in the future.

Probabilities:
Whether you’re long or short on your position, you’ve probably intuitively realized that you have a 50% of making an unlimited profit or loss.

When going long, if the stock price goes up you have a 50% chance of making a profit. If the stock price goes down you have a 50% chance of incurring a loss.
When shorting stock, if the stock price does down you have a 50% chance of making a profit. If the stock price goes up you have a 50% chance of incurring a loss.

Demystifying Selling stock: One would wonder as to how can one sell a stock if one doesn't own it? You'd have to own it to sell it right? If you sell a stock after you owned it, you have basically closed a position that you had open. So back to selling short, how does it work? The process works as such: Say you don't like a stock XYZ (for whatever reason) which is trading at $100 and you think that'll be moving down in near future and want to profit off this downward movement. You short the stock by opening a short position at $100. Behind the scenes, your stock broker is lending you stock (priced at $100) which you sell in open market (for $100). After the down movement to say $90, you buy back the stock at $90 and return it to your broker while keeping the profit of $10. But if the stock moved up to $110, and you are feeling the heat of this $10 loss, you'll have to pay $110 to buy back the stock and return it to the broker.

The Drawbacks:
Buying and selling stocks seems easy enough, but the odds of making or losing money is akin to flipping a coin. Though profit is limitless, so is potential for loss. And to top it off, buying and selling stocks isn’t cheap unless you've cultivated the rare species known as moneygrowingtree. So until then...

Photo Credit: GoogleImages

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Options and Calls

Introduction to Stocks

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