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Call Options Trading - How To Buy and Sell Option Contracts
Posted On Sunday, November 23, 2008 at at 8:01 PM by Finance FanaticA frequent question I have been receiving in emails have been dealing with my decision to trade options for my long positions. I understand option trading can be confusing, but I thought I would dedicate a post to give a quick definition of options trading, more particularly call options rather than puts, considering that calls are mostly what I have been doing lately. Hopefully I can shed some light on why I choose to trade them. If you are currently having grief with your trading platform or are looking for a new platform to trade options with, I recommend TradeKing. Good platform, some of the lowest commissions I have seen, and they are running a $50 credit promotion for sign up before December. You can sign up here: Open an account at TradeKing and get $50.
First, an Option is a leveraged contract purchased at a premium, representing the control of 100 shares of a given stock. In other words, when buying an option, you are buying a contract with the "option" to purchase 100 shares per contract at any time within the contract period. Below is an example of a Call Option table for Apple. First notice that this is an option expiring Fri, Dec 19, 2008 as it says in the upper right corner. This means that the terms of this contract are valid until the given date. You can buy contracts years in advance of expiration. We will use this Dec 19 ending contract as an example. Lets brake it down.
Strike - This is the price per share that, if executed, the buyer of the option contract is able to purchase the stock. For example, circled in red is $90. This means no matter how high apple goes before the expiration date, I have the option to execute my contract for $90 per share.
Symbol - Every option contract has a unique symbol, much like a stock ticker. This just identifies the actual contract. You can track these in your portfolio traders much like regular stocks using these ticker symbols.
Last/Chg/Bid/Ask/Vol - These are all symbols that I am sure most of you will recognize, because they are found in the trading of normal stocks. They trade much like normal stocks. However, lets dive into the pricing of options.
Buying Call Options
You will notice on the $90 option, the Bid is $4.90 per contract. Now be careful, because this does not mean that each contract is $4.90 each. This means that your paying a $4.90 premium per every share you buy. Having 1 option contract representing 100 shares, this means that 1 option contract for this contract would cost you (4.90 * 100 shares) or $490. This represents your cost basis, as well as your maximum loss if Apple decides to tank. Remember, this does not give you ownership of 100 shares, just the right to purchase 100 shares at the "strike price." If you do decide to exercise the contract, you will have to pay the additional (100*90) or $9000 to own the shares.
So lets say we purchase this contract and pay our $490+commission. To do this, we select the "Buy to Open", which means we are opening this contract. As Apple stock continues to move, so will its option price. The only difference is that the option price will move with much more volatility, because of it's 100/1 leverage. This gives buyers a good opportunity to receive bigger gains as they choose to buy stocks at the right bumps. From now until the expiration date, we are now able to resell this contract. So if Apple ends up going up to $95, its option price will go up considerably more on a percentage basis. If we were to turn around and sell it, we would select the "Sell to Close." This would then free us from this contract. Many times you are able to flip an option contract within a few days and double your money. This means you are able to make a nice healthy profit without ever having owned the stock! However, this can get you both ways. It can go down just as fast as it goes up.
As time moves closer to the expiration date, demand will go down for the contract, especially if you haven't reached your "strike price." It is best to try and resell your contract with some time left before expiration. Anytime your option is "in the money", this means that the price of the stock is over the strike price you purchased it for. This usually will give you a good profit if you can get your options in the money.
When you buy an option contract, you are not obligated to exercise it. In fact, I rarely exercise an option contract. My goal is always to be able to flip the contract before it even gets close to its expiration date. However, if you wish to control the shares at the strike price, you're more than welcome to. I would just rather make my profits on the option appreciation, rather than forking up more money to purchase the actual shares. It's less of a hassle for me. If you choose never to resell the contract for whatever reason, your contract would then automatically expire (unless it was in the money, where sometimes banks will automatically exercise them) after the expiration date, freeing you from the contract.
The reason I choose to trade options, especially in this market, are for a few reasons. First, I like the volatility. If I time the bumps right, I will be rewarded far more on my options, than if I were to own stock shares for the same cost basis. Second, the ability it gives me to control hundreds of shares for a minimal basis. Options minimize my downside risk considerably rather than if I chose to own the actual shares. This makes me a lot more comfortable, especially in this market. Options have also been in more demand with the uncertainty of the market. On up days, options can be trading considerably higher, just from the premium people are willing to pay for the security.
Another side to trading options, are playing the short side, or Puts. This usually requires margin trading (which essentially means borrowing from your bank) and can be very risky if the market doesn't go the way you want it to. Sure, you can make a lot of money off of naked shorts, but I choose not to play them as often.
Most every Investment Bank allows for option trading. For some banks, a new application is sometimes required to be approved for option trading. Even with that, many times you are limited to what kind of trading you can do, depending on your experience. They will usually start you off of non-margin option trading to help you learn the ropes. If you can't trade options, check with your bank you trade with. I use Zecco.com a lot as I have found they have some of the most competitive prices for commissions.
I hope this helped those of you that have been wondering how to trade options to see if it's something for you. I have found options to be very profitable for me in this market and a great hedge for my short position. Covered calls can also be a great way to make extra profits on a long position you may be holding. By doing so, you can continue to lower your cost basis.
I hope everyone has a good week and holiday. See you tomorrow.
Wow thanks! i've been trying to figure out option trading for a while, this helped alot. So the min amount we can buy for options is 100 shares (1 contract)?
I consider myself a newbie and I am doing virtual trading and I've got a few questions.
Doesn't volatility drive up option prices? How does it affect your strategy.
In my virtual trades, I can buy an option and sell it off for profit like a day trader. But I've read that this is usually a bad idea. Why so?
You should probably mention the difference between American and European options. Good article!
Will, yes the minimum amount of shares you can control for options is 100 shares. Remember, you don't actually own them yet when purchasing the contract. Just the "option" to purchase them.
Jaryl, Indeed with today's volatility makes prices at a premium especially on an up day. However, it is usually the opposite on a strong sell off day. You can usually pick up a discounted option contract towards the end of a sell off day due to panic. On up days you buy for a premium and on sell off days you sell for a premium, you just need to time the bumps right.
Some analysts think its not a good idea, because of volatility, increase in transaction costs, and because time is against you. Every day that goes by, your option loses its Time value premium more. In normal markets, I would agree, however, in our current market, I believe its a great time to flip options.
For example, in 2 days, I have made 165% on my GDX option. It's hard to do that with a stock. Just make sure you trade reputable company's/sector's options.
Anon,
Sorry, I don't have much light to shed on European options.
Thanks for the article, I look forward to learning more about options. Can you recommend a site for getting options quotes, particularly with intraday historical data, maybe even graphs?
It seems to me that volume of options is much lower than the underlying stock. Any suggestions of minimum volumes to ensure liquidity?
Christian,
There are a list of some of the sites I use for reference on the left column. I also talk in the article of Trade King. They have a great trading platform as well as very low commissions (see link in article for their $50 November bonus sign up).
As for volume, if the option is trading in the multiple hundreds (daily) you should be fine. Options will trade significantly lower than stock because of the leverage basis. But the spreads from the Bid and the Ask should remain relatively low.
Didn't think you needed a margin account to buy puts.
No you dont mbhunter, but if you want to sell puts without owning the stock, you will sell them on margin, which can get scary if you don't cover it, but you can buy puts, much like call options without using margin.
Best lay man description I have read to date. Good Job!!!.
When u click the link on the Symbol, you are presented with more info.
How helpful are the Day's Range and Contract Range data points?
An important warning about puts is appropriate here (especially because I've learned that service reps at discount brokerages may not even be aware of this): At least at some brokerages (eg, TD Ameritrade), an expired in-the-money put option automatically becomes a short position on the underlying symbol.
I was badly caught off guard by this -- especially because I hadn't applied for a margin account before and didn't even think that I could, much less intend, to execute short sales.
In such a case, if you are ignorant like I was, you can quickly find yourself in very hot water: your "safer" put option (where you're only out the premium you paid) can suddenly and shockingly transform itself into an unlimited risk short position.
Good Point Anon. Schwab also enforces the automatic execution of call/puts in the money, which can be very frustrating if you aren't expecting it, so make sure you are aware of that.
Truly a exceptional article. I found this article very helping and learning for newcomers in this field. Very well informed the key points.
I'm trying to figure out the meaning of last, bid, and ask and the difference between them. when you want to buy an option contract you have to look at the amount underneath "bid" but when you want to sell, which number are you looking at?
What kind of account and what level options trading do I need to flip the options like you are saying? I plan to work only with calls - help ASAP!
This is an old article but, I am looking to short TLT with options. I am currently holding TBT as a buy and hold for interest rates to increase. So, if I want to short an ETF and I choose to buy to open do I just select a strike price that's lower than the current price of the ETF? I have heard there's a more conservative way to place calls and that is to "Buy then immediately sell calls". I don't understand how this works. So, I am thinking of buying TLT and immediately sell calls betting that the future price of long treasuries will drop. Cheers, Johnny
I have never been big fan of options. Stock Warrants can sometimes be very attractive.
I am so grateful to read this such a wonderful post. Thank you for discussing this great topic. I really admire the writer for allotting their time for this impressive article. Thank you.
Thanks for this writing. I understand more from your article.
I wonder if you ever run into a time that you cannot sell to close even though you are in the money?
Thanks again
Thank you for this informative post..I have been struggling on how all of this stuff works..
I'm still not altogether there but further ahead than before...
So if you buy a call for $490.00 you have until closing of option to sell it for profit other wise you loose the $490.00..is this correct?
Hank
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Call options trading is a powerful tool for traders who want to take advantage of the movements in a stock or other asset. An option contract gives the holder the right, but not the obligation, to buy or sell an underlying security at a specific price before an expiration date.
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You can buy contracts years in advance of expiration.
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To buy option contracts, an investor selects a strike price and expiration date, paying a premium for the right to buy (call option) or sell (put option) the underlying asset. When selling option contracts, one collects a premium upfront, obligating themselves to buy or sell the asset if the buyer exercises their right, managing risk through strategies like covered calls or cash-secured puts.
Options trading allows investors to buy or sell the right, but not the obligation, to trade an asset at a set price before a specific date, offering a way to hedge against market risks or speculate for potential profits.
It’s great to hear that options trading has been so profitable and useful for you, and your insights on covered calls and hedging are definitely helpful for anyone considering diving into this strategy.
Options trading seems like a whole different level of investing! It’s pretty cool how you can leverage it for bigger gains without actually owning the shares.
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I can buy an option and sell it off for profit like a day trader to the contractor near me. But I've read that this is usually a bad idea.