Option Types
In our previous example, Peter didn’t have enough money so he bought an option, expecting to have the money in 4 months, but also hoping that the land’s value was going to increase. Obviously Peter doesn’t want to buy land at a price that is higher than its fair value in the market.
This type of contract is called a Call Option.
One of the main reasons why traders like to buy options is because option traders can profit when the markets are going up and when they are going down.
Profit when the market is going
When a trader thinks the price of a stock is going to increase in value he can go out and simply buy a Call Option, but what if he thinks that the stock is going to drop in value?
This time round instead of buying a Call Option a trader can buy a Put Option.
What? Profit from a stock going down?
Well, why not? If you can profit from something going up, why not profit from something going down.
Now let’s jump 4 months ahead and see the different scenarios:
1) During the 4 month period a drilling company approaches John, stating that they think that
if they drill into his land,they will find oil. They are willing to purchase the land for half a million Dollars.
In this case, Peter will profit from the deal as he has the right to buy the land at a pre-determined price and date ($100,000). John is obliged to sell him the land if Peter wants to buy it.
2) On the other hand, if a developer decides to build a shopping mall in front of Johns view, Peter can decide not to buy the land. In this case, Peter would have lost his initial premium of $10,000.
Nice story, but how does this connect to stocks?
Let’s say Microsoft is trading at $23 per share.
To profit from the rise you have to have enough cash to purchase the stock.
To purchase 100 stocks you will require $2300. A lot, no?
Well, if you think that the price of the stock is going to rise, you don’t necessarily need to buy the stock itself; you can buy an option instead.
Or in other words, you can pay a premium to buy 100 shares at a later stage in time, but at the price of $23 per share.
When talking about U.S options, 1 option is worth in value to 100 shares.
Conclusion
Call Option – A trader will buy a call option if he thinks that the underlining security will rise.
Put Option – A trader will buy a put option if he thinks that the underlining security will drop.
Just remember it this way- if you think that the security is going to increase then you normally rush to call your broker to buy it before it rises. (Call Option)
If you think that the security is going to decrease then you would rather Put your money aside until the price goes down and then buy it at a latter stage. (Put Option)
