Call And Put Options Diagrams - Are They More Complicated Than Call Options?

Nov. 19, 2010 - PRLog -- Call And Put Options Diagrams

A put option is a contract that gives the holder the right but not the obligation to sell a certain number of shares at a set (strike) price on or before a predetermined date.

A hypothetical example will highlight conceptually a put option:

I am short an ounce of gold at the current market price of $1,000 ("short," meaning I borrowed someone else's ounce of gold, sold it someone for $1,000, and am now obligated to return an ounce of gold to the one I borrowed from). However, you anticipate that the price of gold will decrease over the next month, so you offer me $50 to have the right to sell an ounce of gold to me for $1,000. I could use the extra $50, and do not anticipate the price of gold declining by more than $50 over the next month, so I agree to take your $50 with the stipulation that I will buy an ounce of gold from you for the agreed upon (strike) price of $1,000 if you so choose.

Now I will outline what would happen in two hypothetical scenarios:

1.) Suppose in a month's time there is a glut of supply of gold driving the price of gold down to $500 an ounce. Now it will be profitable for you to exercise the deal we had - that is - sell me an ounce of gold for $1,000 (make me buy an ounce of gold from you for $1,000). Upon exercising the put option you will sell an ounce of gold short to me (i.e. borrow an ounce of gold from someone else to sell to me at the strike price of $1,000). You will now be looking at a net paper gain of $450 ($500 minus the $50 spent on the put contract) to lock in your gains you can buy an ounce of gold in the open market for current prices of $500 to return to the one borrowed from. Get Internet #1 - Call And Put Options Diagrams @ http://tradingcure01.webs.com  and be Successful forever!

Since I was short gold at $1,000 and was forced to buy an ounce of gold from you for $1,000 - I will have effectively broken even. This was an example of selling a covered put; had I not been short an ounce of gold and sold you that same put contract it would have been considered as selling a naked put. In the case of a naked put, I would have suffered losses of $450 by being forced to buy an ounce of gold from you $1000 *$500 above market prices* (then adding $50 for the money paid to me for the put contract).

2.) Suppose in a month's time - currencies crash - uncertainty and fear cause the demand for gold to increase driving the price of gold up to $2,000 an ounce. It obviously will not be profitable for you to sell me an ounce of gold for $1000 (make me buy an ounce of gold from you for $1,000) since the current price is $2000 an ounce. Thankfully for you, options give the holder the right but NOT the obligation - to exercise. So, you will just be out the original $50 spent on the put contract. I, on the other hand will be looking at paper losses of $950 on my gold position since I went short at $1,000 and the price of gold is now $1,000 higher to $2,000 an ounce ($950 because I added the $50 you paid to me for the right to sell).

To summarize, buying calls is a bullish (anticipating the market to rise) and buying puts is a bearish (anticipating the market to fall). As a side note, rarely do I actually exercise my call or put options - since the contracts trade in a market like stocks you can just sell contracts you purchased to someone else prior to expiration. Important to note is how large the spread is in the bid and ask, the avg. daily volume, daily volume, and open interest to aid in determining how liquid the market is/will be for a particular option contract. Also, strike prices are classified as "at the money," "in the money," or "out of the money." At the money being a strike that is exactly the current market price. In the money being a strike that is below the current market price with regards to call options and a strike that is above the current market price with regards to put options. Out of the money being a strike that is above the current market price with regards to call options and a strike that is below the current market price with regards to put options. ATM, ITM, OTM are used as abbreviations.

Equity options expire Saturday immediately following the third Friday of the expiration month. Options trade during the regular market hours of 8:30am to 3:00pm CST. Get Internet #1 - Call And Put Options Diagrams @ http://tradingcure01.webs.com  and be Successful forever!

# # #

Always dream of being Rich? Never able to make a Consistent Profit through trading?
Get Internet #1 - Call And Put Options Diagrams @ http://tradingcure01.webs.com and be Successful forever!