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Over the past few years a hedging tool that was once limited to professional traders has made its way down to the smaller investors of the world. It is a high risk instrument when use it to speculate the underline asset's movement. However, it is a highly useful tool when used in hedging the the underline assets. This financial tool that I am talking about is a stock option. A stock option is a contract that gets its value from an underlying equity. Before one can profit from the use of stock options it is important to understand exactly what a stock option is and how the price of a stock option is derived.
A stock option is a contract that enables two people to make a transaction of stock in the future for a set price. There are two types of stock options, a call, and a put. A call is a contract that two people enter into. The contract is for 100 shares of a particular stock. The seller of the call is agreeing to sell his 100 shares at a predetermined price in the future. This predetermined price is called a strike price. Once the stock is at or above the strike price, the buyer of the call can use his right to buy the 100 shares that the contract is for. Regardless of how much the underlying stock price rises, the buyer of the options contract still has the right to buy the shares at the predetermined strike price. A put is an options contract in which the person who sells the contract is agreeing to buy 100 shares of a stock at a set price. The person who buys the put is agreeing to sell 100 shares of a stock at the agreed upon price, the strike price.
Now that I have explained the difference between a call and a put I am going to talk about how options are priced. The pricing of an option is based off of the price of the stock when the contract is written and the amount of time until expiration of the contract. Option contracts expire on the third Friday of every month. Based off of the amount of time left until expiration and the price of the stock a formula called the Black-Sholes formula prices the premium on an options contract. The premium is the amount of money that the buyer of an options contract has to pay the seller in order to compensate for the risk of time.
Now that I have explained the basic terms and theory involved with options, here is an example of an options trade using one of the safer options trading techniques, selling a covered-call. When you go about selling a covered call you already own 100 shares of the stock you are going to sell. For this example we will use AAPL, which we want to sell. AAPL recently closed at $89.57, and assume we think that AAPL is going to go to $95 and we want to sell it there. Instead of just holding the stock and waiting to the stock goes to $95 we will sell one call contract with a strike price of $95 and an expiration date of July 07 which means that this contract will expire on the Friday of the 3rd week in July. The ticker for this contract is QAAGS.X. For selling this covered-call we will make a profit of 5.65*100 or 565 minus commissions. Now if the stock then trades to $95 or more, the contract will expire in the money and our shares will be sold for $95 dollars a share to the buyer of the contract giving us another profit of $543 (strike price minus current price times 100). The total profit of the trade would be $1108 minus commissions. If the strike price is not hit them we keep the shares and keep the premium that was paid which is $565 dollars. Covered calls are a simple use for options that many investors can take advantage of.
