Hey everyone, this is Kirk here again at OptionAlpha.com, and 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's 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 calls 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 kind of 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 worthless 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 in
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 really 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 premium 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 basically 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
actually 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 actually get a bearish position or build-a-bearish position
in a stock for limited risk, by using a long put option.
And in this case, what you're basically 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 really important.
With a put option, you're basically 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 basically just entering into a put contract as a home builder.
You've basically 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 basically 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 worthless, 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 in the open market.
You just wouldn't exercise that option.
You would let the contract expire, and you'd be happy to just lose your 200 dollar investment,
which is much less.
Okay?
So again, 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 really 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 generally 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 dollars
up or down in either direction, you really 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 really 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 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 fore 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.