A simple rule of thumb with options is that when you think a stock, index, Exchange-Traded Fund or commodity is going up, you should purchase a call option. And when you think an individual stock is going down, you should purchase a put.
Many investors stop there with their options trading. When you’re trading options as speculation (i.e., to bet that the stock is going to soar or sink), you can either close the trade directly and bank your gains without touching a share of the underlying stock. Or, you can profit a different way — by using options to buy shares in stocks you want to own!
The ‘Short’ Cut to Long-Side Profits
You also have the ability to sell options short — i.e., you can “sell to open” calls and puts. But just like there are risks with shorting stocks, shorting options should be done with great care and as part of your overall trading strategy.
Because it’s the most popular way to play the options markets, let’s talk about “buying to open” (i.e., initiating a long position in) options and what it means for your overall trading strategy:
* The call gives the buyer the right, but not the obligation, to BUY stock at a specific price, for a prescribed period of time.
* The put gives the buyer the right, but not the obligation, to SELL stock at a specific price, for a prescribed period of time.
You can use these two instruments to play either side of the options market. When you purchase an option, you are reserving the right to:
* Gain a great entry price point for a stock you want to own (in the case of calls)
* Sell stock at a higher cost than the current market value (in the case of puts), or to
* Close (sell) the option position for a profit without touching a single share of stock.
There are several ways to invest with options. Whether we’re in a bullish market or a bearish one — or whether an individual stock or sector is in its own bull or bear market — we can make money!
How to Add ‘Magic’ to Your Portfolio
Buying calls is a bullish endeavor, so you make profits when the value of the underlying stock goes up. Here’s an example of how you can buy calls as a way of leasing the shares until you’re ready to buy.
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Suppose, with Disney (DIS) trading at $29, you purchase the July 27.50 Calls, and those options happen to be trading at $2. That $27.50 is known as the strike price (or exercise price), whereby you can exercise the right those calls give you to buy the underlying stock.
If shares of Disney go up $1, $5, even $10, you would have the right to buy stock at $27.50 during the life of that contract — in this case, until the third Friday in July, when the option expires.
Or, if you don’t wish to purchase stock, you can sell your calls (“sell to close”) — and thus, your right to buy shares at that $27.50 strike price — to another trader. And with the stock performing well, you can garner substantially more than your original $2 investment.
Buying puts is similar in that you still want to see the value of the options go up, but at the same time, you are forecasting that the price of the underlying stock goes down. Staying with the Disney example, if you think the $29 share price could go lower, you might buy the July 30 Puts.
This would now give you the right to sell stock at that $30 strike price — or, said simply, you’d have the right to put stock to the put-seller at $30 a share, even if it would trade down to $25. Yes, they would have to pay you nearly $5 per share more than the market value if your estimation turned out to be true!
In this example, in order to exercise your put, you would need to own the underlying shares to be able to “put” them to someone at the agreed-upon strike price of $30 a share.
You don’t have to own the underlying shares to buy (“buy to open”) puts or calls, so don’t let that keep you from buying options and using the incredible leverage they give you to play stocks as they’re going up or down!
And again, if you don’t want to take advantage of selling the stock, if the value of the options goes up, you can sell your right to make that move by closing (selling) the option position. If your prediction about the direction of the stock and the option were right, you stand to profit either way.
There are so many ways to “win” at the options-trading game, but familiarizing yourself with the powerful tools you have at your fingertips will help you to better plan your strategy and, in turn, anticipate and enjoy the rewards.
