In this video, we are gonna be going over the differences between all and put options, and again, I think this important that you take the time as you're early in your options trading career, or if you're new to option trading, that you really really understand the differences between these two because these are the building blocks for everything that we can do as a trader.
So again, there are only two types of options contracts. We got calls and puts, and everything that you can do in this space revolves around the use of these two contract types. So, let's dig a little bit deeper.
Again, we're gonna look at just long calls and long puts today. We'll talk later on in the next video about buying and selling either call and puts and how you can, you know, kind of change these risk diagrams.
All right, so the first thing we're going to do is, we're gonna look at an example of a call option. Now long call option strategy is the most basic trading strategy, whereby you're gonna go out and buy a call option with the expectation that the price of the stock will rise significantly beyond the strike price before the expiration date.
In this case, we're going to look at, an example that we have here is buying a 40 strike call option, so this is where the payoff diagram pivots and moves higher.
Now your expectation, obviously, is that the stock price is well beyond the 40 price at sometime in the future before expiration ate. So if right now the stock price is at say, let's say 30 dollars, you're going to hope that it's beyond 40 dollars because that's your strike price. It's beyond that price point in the future for you to make money.
Now, compared to buying the stock shares outright, a call option buyer uses the power of leverage that we talked about previously, since one contract will control or leverage 100 shares of stocks, so that's the benefit to doing this.
We have power and leverage, and we can pick your points. We assume that maybe the stock is going to go higher than 40. Let's continue here further. These are very easy to set up, since it's just a single option order, and that's what we're gonna start with here as basics.
You simply buy a call option with the strike price and expiration period you desire. In this case, or this example, you might buy a call option, which is say, at the money, or you might buy a call option that is out of the money if you're even more bullish.
An at the money option would be if the stock is trading at 40 dollars, you would buy the 40 strike calls. If the stock was trading at 30 dollars, you might buy out of the money, meaning it's not quite yet, or the stock price isn't quite at the strike price, and you might buy an out of the money 40 strike call option.
So again, it all determines where you buy the options depending on how bullish you are and how much time you need until expiration. The maximum loss is limited in call option strategies.
It occurs that the investor still holds the call option and that expiration and the stock is below the strike price. The option would then expire worthlessly and the loss would be the price paid for the call option. So again, in our example here, we're assuming that you're going to pay 200 dollars for this options contract.
Now, think about it logically here. If you are assuming that the stock is well beyond the 40 strike price, meaning the value of the stock at expiration is beyond 40, that would be a good thing if the stock is, let's say, up at 50 because then you can buy the stock at 40, using this call option and resell the stock immediately in the market for 50 dollars per share, netting you a 10 dollar difference for each share.
Okay, so that's only if you assume that the stock is going to be higher than your strike price. Now let's say that you come back in and you thought that the stock would come up to beyond 40 dollars, but now at expiration, the stock is only up to 30 dollars, there'd be no reason for you to go out and buy the stock at 40 dollars when it's only worth 30 dollars on the open market.
You just wouldn't exercise your option contract. You would actually go out, and if you wanted the stock, you would buy it at the current market price of 30 dollars per share.
So this is where, again, I think some of the reduced risk features of options trading come in, because now, you would be more than happy to lose the 200 dollars that you would have, or that you're gonna lose on this contract because now, that's less than what you would have lost if you had bought the shares outright at 40 dollars, and now they're worth 30 dollars per share. Okay, so that's the power of using these options contracts.
Now again, with call options, the profit potential is theoretically unlimited, but the best that can happen is that the stock price to raise to infinity. Obviously, we say theoretically unlimited but, you know, option prices are going to be range bound, you know, within certain parameters.
There's no stock that's gone to infinity, right? At some point, the option contract does reach parity, though, and what that means is that every dollar moved in the stock, the dollar, the value of the option goes up by a dollar as well. Okay, that's on the further edges.
Now, as implied volatility increases, which we'll talk about later on here in this module, it does have a positive impact on the strategy, everything else being equal. It also really tends to boost the overall value of long options because there's a greater probability of that strike price being passed by expiration.
And this just means that if the market is volatile, and we have a stock that's sitting at 40 dollars, and there's a good chance that it could swing between 30 and 50 and 30 and a 50, then there's a good chance that this options contract may be pretty valuable.
But, if the option, or if the stock is trading right now at 40 dollars a share, and the market's not volatile, meaning that the stock really doesn't move more than like a couple pennies per day, maybe down a couple pennies, up a couple pennies, then the value of this options contract is gonna go down because there's not a good chance that the stock is gonna swing into a potential profit zone. Okay, so that's the impact of volatility.
Now, as time passes, it has a negative impact on the strategy. That goes for all options, long options, because options have a finite life, and as they go quicker and quicker towards expiration, the value, or the time left for the stock to move into a favorable zone, is gonna be less and less.
Once the time value disappears, then all that remains is the intrinsic value. So the difference between the strike price and the current price of the market. For in the money options, that's, like I said, the difference between strike price and the current price of the market.
For out of the money options, they're gonna be out of the money, so if the stock ends at 30 dollars a share, and the strike price is 40 dollars, then in this case, the call option has no value at 30 dollars, and the options contract basically expires worthless, the option buyer loses their money, the option seller keeps the entire 200 premia as a credit.
Now, at expiration, the strategy breaks even if the stock price is equal to the strike price plus the initial cost of the option contract. Anything above this level at expiration would be the additional profit for the option buyer. So again, break even prices at call options, long strike price plus the premium that you paid to get into the contract.
So, let's look at an example here. The strike price in this case, like we talked about, is 40 dollars a share. If you bought one 40 strike call option for 200 dollars, the 200 dollars is the debit that you paid to get into it. It's your consideration or your premium.
That means your max loss is your 200 dollars, or your cost. It doesn't matter where the stock price is. Anywhere below 40, you can only lose 200 dollars because you don't have to buy the actual shares. You're not obligated to buy those shares.
Your max profit potential is theoretically unlimited in this case, and your break even point, in this case, is 42 dollars. That is the value of the strike price plus the option contract value, which is really ... 2 dollars is a value, not 200 dollars debit.
That's the actual value of the contract, but when you actually see the contract go across, you're gonna pay 2 dollars for that contract, so the actual break even price in this is 42 dollars, meaning, even though you bought the 40 strike call options, you really need the stock to move to 42 dollars or higher to be profitable at expiration.
You'll start making money as the stock goes beyond the 40 strike, but you really won't make any money net of your cost to get into the trade until the stock moves beyond 42 dollars. So hopefully that's a really good example of a basic long call option.
All right, so now let's turn things around, and let's look at put options. The long put option strategy is the second most basic options trading strategy, whereby you go out and buy put a put option with the expectation that the price of the stock will drop significantly beyond the strike price before the option's expiration date.
Compared to shorting the shares outright, a put option buyer is using, again, the power of leverage, since one put contract will control 100 shares of stock.
Now, this is where you can get a bearish position or build-a-bearish position in stock for limited risk, by using a long put option.
And in this case, what you're saying is your strike price becomes the price at which you guarantee that you're going to sell shares in the future. So, follow me on this if you're new because I want to make sure we cover this in detail, and we're all good to go from here going forward because it's really important.
With a put option, you're making an agreement with somebody else that says you will sell shares in the future at 40 dollars per share. That's your strike price. That's the point at which you're going to sell the underlined shares.
Now your goal, if you've already pinned your selling price in the future of 40 dollars per share, your goal now is to buy the shares later on before you sell them to somebody else for less than that value.
So, you might go out and buy the shares when they go down to 30 dollars, and then you resell them to somebody else that you've already guaranteed that you're going to sell them to at 40 dollars a share.
Okay, the way that I always explain this is that let's say that you're a home builder, and you're building a house for somebody. If you agree to build that house for them for 100,000 dollars, they agree to pay 100,000 for that home whenever it's done.
So you're just entering into a put contract as a home builder. You've determined what price you're gonna sell that home to them, which is 100,000 dollars.
Now your goal and mission is to build that house for less than 100,000 - materials, labor, permits, everything - you want to outlay less money, go out a physically buy the materials, and hire the people to build the house for less than you've already predetermined to sell the house for to the home buyers, which is 100,000 dollars.
If you can build the house for 80, and you've already got a person lined up to sell the house to for 100,000 dollars, then you make that difference as a profit. It's the same way with put option contracts.
You're going out, and you're pre-selling the stock at some price in the future and hoping that you can buy the stock at a lower price in the future. Meaning that the value of the stock goes down, and therefore, the profit in the trade goes up incrementally as well.
Okay, so hopefully that makes sense, that's a good analogy. I use that, that home builder analogy a lot. Now, these are very easy to set up since again it's a single order. You simply buy a put option with a strike price and expiration period that you deserve.
In our example, we're buying one at the money put option, meaning that the stock price could be at 40 dollars. We buy a 40 strike put. That's where the option payoff diagram pivots.
If we wanted to buy an out of the money put option, let's say that the stock is trading at 50 dollars a share, we would then be buying an out of the money put option at 40 if the stock is trading at 50. Our 40 strikes are out of the money, meaning we need to move down to at least 40 dollars for us to be in the money.
Now again, the more bearish you are, the further out of money and the lower that you'll buy those put option contracts on whatever you're trading. The maximum loss again with long options is limited.
It occurs if the trader is still trading the put option at expiration, and the stock is above the strike price, okay? In this case, the option would expire worthlessly, and the loss would be the price paid for the put option.
Now, as opposed to our home builder example, in this case, with an option contract, you are not required to sell the shares. You might pay a premium to enter into this contract, but you are in no way required to sell shares at 40 dollars.
It's your choice. It's your option as the option buyer. The option seller does not have that choice, but as an option buyer, you do. So, if the value of the stock is now 50 dollars at expiration, there would be no logical reason for you to sell the shares at 40 dollars to somebody else when you have to go out and buy the shares at 50 dollars on the open market.
You just wouldn't exercise that option. You would let the contract expire, and you'd be happy just to lose your 200 dollar investment, which is much less. Okay? So again, the profit potential is theoretically unlimited just to zero.
Obviously the stock can only drop to zero, so we have unlimited, and you'll see unlimited in a lot of places, but it's real to zero. You can only make as much money as the current value to zero.
At some point, the options contract again does reach parity with the short stock, meaning that there's no additional value present in owning the option. That's usually if the option goes very deep into the money, and at that point, every dollar move down that the stock makes, the option value goes up by a dollar as well.
Now all things being equal, an increase in volatility will have a positive impact on the strategy just like we looked at with call options.
When volatility increases and the market is more volatile, meaning that it could swing from 40, all the way down to 30, all the way back up to 50, back down to 30, there's a bigger chance that the stock might swing into your profit range.
Versus a market that is not volatile, that stays around 40 maybe swings a couple of dollars up or down in either direction, you don't have a lot of value. So as volatility increases, it tends to boost the value of these options, because there's a greater chance of the stock swinging into your profit zone, okay? So that's a key concept as well.
Now, the passage of time, just like with call options, with a long put option, a long call option always negatively impacts the options. Options are finite. They have a definitive date in which they expire, so as time passes and time erodes, then the value of these options goes down because there is less time for the stock to swing into the potential profit zone.
At expiration, the strategy breaks even if the stock price is equal to the strike price minus the initial cost of the put option. Again, anything below this level at expiration would be additional profits for the option buyers, so break even price here is the long put strike.
In our case, 40 dollars minus the premium of 200 dollars and basically an options pricing term, it's 2 dollars when you actually enter the order and so that give us a break-even price of about 38 dollars on this particular security.
So again, example here. Stock price is at 40. You buy a 40 strike put option for 200 dollars. In options pricing terms, when you actually go into your broker platform, you're gonna enter an order that's gonna say two dollars actually controls or is valued at 200 dollars.
That's the price that you pay. That's also your max loss. You can't lose anything more than that. And then again, profit potential is unlimited to zero, so obviously the stock can't go below zero.
The break even price, strike price of 40 dollars minus the value of the option that you paid, which is two dollars, gives us a break even price of 38 dollars.
In this case, even if you bought the 40 strike puts, because of the value in buying those put options, or how much you had to pay to enter into that contract, your actual break even price is 38 dollars, so you'd want to see the stock move down to at least 38 dollars before you start making money net of the cost to get into the contract.
So hopefully this has been really good to go through these differences. I know we covered a lot of things. There's probably some stuff that you didn't understand or some terminology, and we'll keep doing it.
We can't cover everything in one single video. But it's important to remember that calls and puts are the building blocks for everything we'll be doing here.
Next week, we'll be talking about the difference between buying and selling options, or if you're already part of our membership at Option Alpha, you can go right to that video. That's the next video in this track.