The following is an excerpt from the eBook, Options Trading 101, authored by MarketClub Options lead trainer, Trader Travis. Learn more about MarketClub Options and how to obtain this entire eBook.
If you recall from the earlier chapter I told you that buying put options gives you the right, but not the obligation, to sell shares of a stock at a specified price on or before a given date.
A "put option" will increase in value when the underlying stock it's attached to declines in price, and it decreases in value when the stock goes up in price. Read that sentence again. Really, do it.
Most of the people I teach have a hard time wrapping their head around the concept of making money when stocks fall in price. But once I break down how calls and puts work it should be easier to understand the above concept.
Remember, put options give you the right to "sell" a stock at a specified price. When you are buying put options you are preparing for, expecting, or want the price of the stock to decline.
Imagine that, wanting a stock to fall so you can make money. It's so counterintuitive, but that's just how these contracts work.
Over time you will begin to like bear markets (market crashes) as you make your money much quicker because stocks fall faster than they rise.
If you bought a "May 120 put option" on stock XYZ, the option (contract) gives you the right to "sell" stock XYZ for a price of $120 on or before the 3rd Friday in May.
If stock XYZ falls below $120 before the 3rd Friday in May you have the right to sell the stock for more than its market value.
So let's say that stock XYZ falls in price to $50. Everyone else who owns the stock has to sell it for $50, but you own a contract that says you can sell it for $120.
Can you now see why put option contracts go up in value as the underlying stock goes down in price?
The further the stock falls in price below your strike price ($120) the more valuable the option becomes.
Essentially, you hold a contract that says you get to sell something for more than its market value.
Have you ever been in a losing stock trade and wished you could sell it for more? Or, have you ever lost money in an investment and hoped it went back up in value?
If you owned this stock and was facing the pressure of selling it for $50 you would love to own a contract that says you could sell it for $120.
But let's say you don't own the stock, but instead just bought the put option because you thought the stock might fall in price.
Do you think that contract has increased in value? Yes it has, and you can easily sell it into the options market for more than you paid for it.
Put Options: Will increase in value when the underlying stock it's attached to declines in price.
Now let's look at the situation in reverse...
Let's say stock XYZ was trading at $300 a share. Who would want to buy a contract from you that gives them the right to sell stock XYZ for $120 a share when they could easily sell it for $300 on the open market?
No one, which is why put options decrease in value as the stock goes up in price.
NOTE: Call options and put options function opposite of each other. So if you understand how one of them works it's the exact opposite for the other.
Now let's move on to call options...
Buying call options gives the buyer the right, but not the obligation, to buy shares of a stock at a specified price on or before a given date.
Call Options: Will increase in value when the underlying stock it's attached to goes up in price, and decrease in value when the stock goes down in price.
In the example above let's say you bought a "May 100 call option" instead. This option gives you the right to buy stock XYZ for $100 on or before the 3rd Friday of May. Now imagine that stock XYZ comes out with a new product and the stock goes up in price to $150.
Per the terms of that contract (call option), you get to buy it for $100.
You can purchase the stock at a $50 discount or sales price when everyone else has to pay the full retail price of $150.
So as the stock goes up in price, the May 100 Call option goes up in value.
And vice versa...
If stock XYZ falls in price to $75 a share who wants to purchase a contract that gives them the right to purchase it at $100 when it's selling for cheaper on the open market.
If you exercised the rights of the contract and bought the stock at $100 you'd immediately be at a loss of $25 since the stock is trading for $75 on the open market.
That's the equivalent of someone trying to sell you a car for $2,000 when the retail value of it is $1,500. Thus why call options decrease in value when the stock goes down in price.
I want to personally thank you for your patience thus far. I used to be bored with options trading basics until I realized they were the key to succeeding.
I know we have covered a lot in this little ebook, but a sad fact is that all of that mumbo jumbo can be summarized with two sentences.
You "buy" a Call option when you think the price of the underlying stock might go up in price.
You "buy" a Put option when you think the price of the underlying stock might go down in price.
Of course, there is much much more to it and knowing it is a lot different than applying it, but for now just remember those two points.
Keep an eye out for my next post.
MarketClub has been helping thousands of traders successfully navigate the markets for the last decade. But now, with MarketClub Options, members can learn how to accelerate their profits with the power of leverage and a strategy built for long-term success. Trader Travis will show you step-by-step how to find, execute and manage winning options trades. Watch his 10 Minute MarketClub Options Strategy.