Question: Call and put options?
So I've never used options before when trading stocks and I know it can be very lucrative if you play the right stocks... however I do not know anything about it really, I have a general concept from what I've read on the internet but that's about it. So I have a few questions to try to grasp how options work a little better. I'm going to try to use some examples of what it looks like to me,
Would this be short selling?
So say stock XYZ is currently trading at 23.45 per share - so I buy at 23.45 on Feb 15
I think its going to drop to $23.00 (strike price) per share (-0.45 cent difference) by Feb 25
I buy 2 "books" with 100 contracts each, and it does drop at or below 23.00 sometime between Feb 15 - Feb 25 (I would have essentially made 90.00 minus brokerage commissions).
Does that sound about right?
Also, what would happen if It went up to say $25 a share and never went below $23 in that time? How would I exactly lose money in this deal? Would I be forced to buy 200 shares of XYZ at $25 a share then? or would I just lose the difference from $23.45 to $25 so roughly $1.55 per contract x 200? I'm sorry its kind of a long questions but I would really like to understand more about this... 5 stars to anyone who can answer all my questions. Thank you in advance!
Answer:
A short sale is when you borrow shares from someone else for a fee and then you sell them immediately. Usually the funds from that sale are held in an account until your position is closed out.
You sell the shares immediately because you believe that the price will go down. If you are correct and the price does go down you will then re-purchase the shares at a lower price and then give them back to whomever you borrowed them from.
If the price goes up you will have to re-purchase the shares at a higher price which means you will have lost money. In either case the shares must be returned to whomever you borrowed them from.
If you are long something it means that you own it. If you are short something it means that you have sold it.
The difficulty with selling short is that if the price moves up rapidly you can lose a lot of money. This is really something that you want to do only if you can afford to take a loss. Even experienced short sellers can lose money.
A put is a contract to sell something at a given price for a specified period of time. It gives you the right but not the obligation to sell it for the strike price. A Call is a contract to buy something at a given price for a specified period of time. It gives the buyer the right but not the obligation to buy something at a given price for a specified period of time. The price at which it is to be bought or sold is the "strike price". People buy puts or calls to lock in a given price for a given period of time. There is a market for trading these contracts. An example of why someone would find this useful might be a farmer who sells oranges. He would want to guarantee that his oranges would sell for a given price so he can pay his bills when the crop comes in. He is willing to give up any chance that the price will go higher because the security of knowing that he will have enough to pay his bills is enough for him.
This isn't just done with commodities like oranges. It can be done with almost anything. For example: Say your house is worth $400K now and I would like the opportunity to purchase it for two years. I might buy a call option from you. If you are willing to sell me the right to buy it for $400K for two years then I might pay you $5,000 for that right. So for a period of two years you are obligated to sell me your house for $400K no matter what the price is. If it goes down then the option will expire worthless. If it goes up then I have made money.
The opposite would be true of a put option. If you want to make sure that your house sells at a certain price you would purchase a put option guaranteeing that it would sell at a certain price (say the original $400K) for a given period of time. If the price of the house goes down then you have preserved your original $400 K. If it goes up then you have lost the opportunity to sell it for a higher price during the time that the contract is active.
There is an active market for buying puts and calls for stocks, bonds, and commodities.
As someone once said: Keep It Simple, Stupid. I know many people working in the investment business who don't understand options! Start from a basic, simple explanation then work up from there. Most people try to dive in at the top!
I think you might have confused the payoff of put options with short selling. In your example, if you had sold 2 put options at strike 23, the payoff from each put when the stock dropped to 23 from 23.45 woud be less than half of 0.45 assuming volatility had not changed. The reason is that for each $1 drop in the underlying stock, the price of an at-the-money put option would increase only about $0.50. So say the put option was priced at 1.56 for the appropriate volatility,interest rate, dividend and time to expiry, then when XYZ was at 23.45, the put woud be around 1.76 when the stock dropped to 23.
Buying a put option also gives you the right sell, but not the obligation to do that. So if the price of XYZ is above the strike, you lose what you paid to buy these options.
If you want to have a more in depth understanding about the properties and payoffs of the options, you'll need to do some more reading. Concepts such as options greeks are essential.
You either buy and sell shares or you pay a premium for an option to buy or sell shares. There's only four options to understand. Start with two: CALLS and PUTS. Buy CALLS if you think underlying stock is going up. Buy PUTs if you think underlying is going down. The other two optuions are on the opposite side of those: That is WRITING (selling to open) CALLS and PUTS. So, taking the opposite view, writing a CALL you think underlying is going down. Writing a PUT you think underlying is going up.
Once you know that without thinking about it move on to the strike: in the money, at the money, out of the money.
Then look up and read about the Greeks (no, not the ones who've blown all their money!)
So the first thing you realise is that trading options is no different to trading stocks, or, for that matter, betting on raindrops falling down a window pane: you only win if you guess the direction correctly. With one big exception: options are a GEARED (Leveraged in American language) product. You can make a lot more money if you get it right and, yes, you've guessed it, lose a lot more if you get it wrong.
P.S. I think everything in your question you got wrong!