By: Matt Funaro

Explaining Options (Buying Side)

Learning about options can be very intimidating, and there is a lot to learn before you get started. This article is going to explain what an options contract is, and the ways that you can be on the winning side of a trade. There are two types of options, a “call” option and a “put” option. They both function similarly, the difference being a call option represents a bullish position, and a put option represents a bearish position. For the purposes of simplicity, commissions will not be calculated into these examples, but please be aware of what your broker’s commission structure is for options before trading.

What is a Call Option?

A call option is a contract that allows the buyer of the contract to purchase 100 shares of a certain stock, at a specified price (strike price), before a certain date (expiry), in exchange for a certain amount of money (known as premium). For example, a call option with a strike of $10, an expiry 2 months away, and a premium of $0.50/share, would give the owner the right to purchase 100 shares of a specified stock for $10, regardless of the current share price, any time before the next 2 months. The buyer pays the seller a $50 premium ($0.50/share x 100 = $50) for the ability to do this.

Let’s break this down with an example of a call option, and how you would profit from purchasing one:

Stock ABC is trading at $10 a share, and you think the stock is going to go up

You can buy a call option with a strike of $10 for a $0.50 premium that expires in 2 months.

This contract entitles you to buy 100 shares of stock ABC at the price of $10 any time between now and 2 months from now (when it expires).



Since the ability to buy a stock at a set price is something that you can’t do in the normal market, you have to pay somebody a premium of $0.50/share, and since the option tracks 100 shares of stock, your premium would be $50.



To summarize this example, you are paying somebody else $50 for the right to buy 100 shares of stock ABC for $10 anytime in the next 2 months, no matter what the current price of the stock is during that time.

In what situation would I profit from this trade?

First find your “breakeven” price with the following for mula: Breakeven Price = Strike Price + Premium Here, the breakeven price would be: $10.00 + $0.50 = $10.50

This breakeven price simply means that the stock price would need to be above $10.50 for it to be profitable for us to exercise our right to purchase those 100 shares at the strike of $10.

(100 shares) x ($10 strike) + ($50 premium) = $1,050 (total cost of 100 shares)



With your average cost per share being $10.50 ($1,050/100 shares) anything above $10.50 would be profitable, just like any long stock position.

Winning Example

Stock ABC announces fantastic sales, and the stock price goes to $12/share.

You would then execute your options contract, thus owning 100 shares of stock ABC for $1,000

100 shares x $10/share = $1000 cost

You can immediately sell those shares at the current market price, making your total profit:

$1,200 (current value) – $1,000 (price paid) = $200 profit



$200 (profit) – $50 (investment) = $150 net profit



Despite the underlying stock moving just 20%, we would profit 200% on our original investment of just $50.

Losing Example

Stock ABC doesn’t release any news, and stays flat at $10/share during the 2 months that the contract is valid.

In this situation, it would not be profitable for you to exercise your contract, so you would let your contract expire worthless.

$0 (profit) – $50 (investment) = – $50 loss, or -100% ROI, despite the underlying stock moving 0%.

What is a Put Option?

A put option is a contract that allows the buyer of the contract to sell 100 shares of a certain stock, at a specified price (strike price), before a certain date (expiry), in exchange for a certain amount of money (known as premium). For example, a put option with a strike of $10, an expiry 2 months away, and a premium of $0.50/share, would give the owner the right to sell 100 shares of a specified stock for $10, regardless of the current share price, any time before the next 2 months. The buyer pays the seller a $50 premium ($0.50/share x 100 = $50) for the ability to do this.

Let’s break this down with an example of a put option, and how you would profit from purchasing one:

Stock ABC is trading at $10 a share, and you think the stock is going to go down.

You can buy a put option with a strike price of $10 for a $0.50 premium that expires in 2 months.

This contract entitles you to sell 100 shares of stock ABC at the price of $10 any time between now and 2 months from now (when it expires).



Since the ability to sell a stock at a set price is something that you can’t do in the normal market, you have to pay somebody a premium of $0.50/share, and since the option tracks 100 shares of stock, your premium would be $50.

To summarize this example, you are paying somebody else $50 for the right to sell 100 shares of stock ABC for $10 anytime in the next 2 months, no matter what the current price of the stock is during that time.

In what situation would I profit from this trade?

First find your “breakeven” price with the following formula:

Breakeven Price = Strike Price – Premium



Here, the breakeven price would be: $10.00 – $0.50 = $9.50

This breakeven price simply means that the stock price would need to be below $9.50 for it to be profitable for us to exercise our right to sell 100 shares at the strike of $10.

Winning Example

Stock ABC announces horrible sales, and the stock price goes to $8/share.

From here, you would buy 100 shares of Stock ABC.

100 shares x $8/share = $800 total cost

Since you now own 100 shares at a cost basis of $8, you would simply use your option contract to execute your right to sell these shares for $10.

($10/share x 100 shares) – ($8/share x 100 shares) = $200 profit



$200 (profit) – $50 (premium) = $150 net profit



Despite the underlying stock moving just 20%, we would profit 200% on our original investment of just $50.

Losing Example

Stock ABC doesn’t release any news, and stays flat at $10/share during the 2 months that the contract is valid.

In this situation, it would not be profitable for you to exercise your contract, so you would let your contract expire worthless.

$0 (profit) – $50 (investment) = – $50 loss, or -100% ROI, despite the underlying stock moving 0%.

What are the benefits of using options?

One of the main reason traders use options is limit their risk on a trade. If one was to simply buy 100 shares of stock ABC at $10, your total investment would be $1000. But as we saw with this example, you would only need to commit $50 to the trade. If ABC goes to $0 overnight, you would lose all $1000 you had invested. If you decided to buy an option contract, you would lose the $50 you spent on the contract premium, but you are limited to a maximum of a $50 loss.

The other benefit as displayed above, is a very low capital requirement. You would “control” 100 shares of stock for just $50, whereas buying the stock outright would cost us $1000. Sure, that 20% move would net $200 with the stock trade, compared to $150 when trading options. However, the return on investment of 200% with the option is much greater than the 20% returned from the same stock trade.

What are the disadvantages of using options?

Options are a leveraged derivative of the underlying stock, making them much more volatile. This means that something as small as a 5% move in the stock price could cause the value of an options contract to fall 50% (this is just an estimate). So, while you do see the benefits of being leveraged to the upside, this applies in both direction. When buying an option contract, you still hold zero equity in the company. If a stock price falls, you can always hold the stock to hope for a rebound. Due to options having a definitive timeline (set by the expiration) there is a limited amount of time for the stock to recover.

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