- March 19, 2018
- Posted by: fortunatetrader
- Category: Trading 101
What is a Call option and a Put option and how does it work? — Part1 – Buying a CALL
Make sure you understand what the options are first: What is an Option?
I’m going to cover the different kind of options in a series of four articles.
Options give you the RIGHT to do an action.
BUY or SELL in this case.
You have only two different kinds of options:
Read and read again slowly
As we have seen, “Specifically, options are contracts that grant the right, but not the obligation to buy or sell an underlying asset (called a stock or an index) at a set price on or before a certain date. The right to buy is called a call option and the right to sell is a put option.” – Investopedia.
People who buy options are called holders and those who sell options are called writers.
So you can just do 4 things with options:
-BUY a CALL
-BUY a PUT
-SELL a CALL
-SELL a PUT
“Is that it?”
I want to go against the financial industry that stipulate that it is hard to understand and very risky to trade options.
You will see me saying this often.
Risk is about not knowing!
When you do know what you are doing and you understand the downsides, what are the risks?
What is buying a CALL option?
Do you own a house?
If you do, you know that you had to “get” the money to buy it.
Maybe that was your money or the bank’s money.
Let’s say that you want to buy a $100 000 house but you don’t have the money or don’t qualify with the banks for a mortgage.
You decide to tell the seller that you want to reserve your right to buy this house in one year for 100K, since you don’t have the money in hand today.
The seller accepts your offer of having the right to buy his house in one year for 100K but for this transaction he will request a small fee upfront from you; let’s says $1 000.
This is a fee not a down payment.
It seems fair that you sign a contract that will give you the RIGHT to BUY and that you give him a certain amount of money since the seller takes his house off the market during that year.
Well, my friend, you just BOUGHT A CALL option.
Let’s say that in one year the real estate’s market went up like crazy.
The house value in the market is now $150 000.
You might want to exercise your right of purchasing the house at $100 000.
Even if the price value in the market is at 150K at this moment.
You have signed a contract that gives you the right to buy it at 100K. Great!
It cost you $1 000 to now have the right to buy something at 100K that you can sell right back in the house market for 150K.
How cool does a 49K profit sound like?
That is buying a CALL option.
You think that the market will go up; that the market will be bullish.
“But what if the house market stays the same or even worse, drops the price of this house to $80 000 instead of going up?”
If that occurs, you mightn’t want to exercise your RIGHT.
Why buy something at 100K that is now worth 80K?
You might want to just let the contract expire and move on.
Remember? We had settled the contract period for a year.
You will have lost your $1 000 but won’t have bought something that is “In the red” already, or what we call “Out of the money”.
Today we have learned about one of the four ways of trading options: buying a CALL option.
In short, a CALL option is called a “CALL” because the owner has the right to “call the stock away” from the seller. It is also called an option because the owner of the contract has the RIGHT, but not the OBLIGATION, to BUY the stock at the strike price. In other words, the owner does not have to exercise the option and buy the stock. If buying the stock at the defined price is unprofitable for him, the owner of the CALL can just wait the predetermined timeframe and let the option expire.
– Make It Happen –