Call and put options explained
Because you can force the seller of the option to buy your shares at a price above market value, the put option is like an insurance policy against your shares losing too much value. Purchasing options can give you a hedge against losses, and in that sense, they can be used conservatively. But there are many options strategies that amount to little more than gambling and can increase your risk to a frightening degree.
Remember, when a call is exercised, stock must be delivered by the seller of the call. If a strong market advance or a major announcement by the issuer has driven the share price up sharply, your losses could be enormous. As indicated, many option strategies involve great complexity and risk. For this reason, not all options strategies will be suitable for all investors. In fact, with the exception of sophisticated, high net worth individuals who can afford and are willing to incur substantial losses, the writing of puts or uncovered calls would be unsuitable for just about everyone.
Nevertheless, brokers sometimes engage in inappropriate options trading on behalf of customers who do not understand the risks. If you have lost assets because your stockbroker was engaging in options trading, please contact us today. You eat the premium you paid as a loss. However, if your house does burn down, you gain above and beyond what you paid for in premiums.
Now, suppose you own shares of GE. You hold GE stock because you believe in the company. However, you're a little nervous about what's going to happen to the stock in the short term.
To alleviate your anxiety, you can buy put options. In effect, this limits the extent of your loss to just the amount you paid for the put options - i. Also, like insurance, if the bad news never comes and GE goes up, you don't gain anything from having insurance.
You'll just have eaten the insurance premium as a loss. While put options and insurance are very similar, they do have one difference.
Whereas you can only buy insurance on what you already own, you can buy put options on stocks you don't own. In other words, I don't need to own GE stocks to be able to buy put options. If I buy put options on GE without owning the stock, it becomes a gamble that GE stock will fall in the future. This is like buying insurance on your neighbour's house, because you think they carelessly play with fire all the time.
So when does it become worthwhile to purchase put options? Whether you're wanting to insure parts of your portfolio, or bet against a specific company, it really comes down to one thing: Sometimes, the market offers a low price for the options i. Sometimes, the markets offer a high price for the options i.
Buying options only make sense when options prices are low. So how do we know whether option prices are hight or low? That's the topic of the next article of this series, so stay tuned. If you buy put options, it's as if you bought insurance against a stock falling out of bed. If the stock does fall out of bed, you make money on the put option.
If not, the option becomes worthless, and you lose what you paid for the option. If you buy put options on stock you already own, the options act as a safety net. However, you can also buy put options on stock you don't own, and if you do that, it becomes a bet that the stock in question will fall.
Whether it makes sense to buy put options depends on the price you pay, and we'll look at how to value such options in the next article in this series.
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