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Today, I want to break down the basics of how options work, starting with calls and puts.
What Are Options?
At their core, options are a contract between two parties. One side gives the right, but not the obligation, to buy or sell an underlying stock at a specific price by a specific date. The buyer of an option is paying for that right — the seller is agreeing to take the other side of the trade.
Calls vs. Puts
There are two basic types of options: calls and puts.
| | • | | Call Option: This gives the buyer the right to purchase a stock at a specific price (called the strike price) before a set date (called the expiration date). When you buy a call, you want the stock price to go up. The higher it goes above the strike price, the more money you can make.
| | | • | | Put Option: This gives the buyer the right to sell a stock at a specific price before a set date. When you buy a put, you’re betting the stock will go down. If the stock falls below the strike price, you make money by selling it at the higher price. |
Buying and Selling Options
Now, the trick comes when you look at the other side of the trade. If you’re selling an option instead of buying it, your goal is the opposite.
| | • | | Selling a Call: You’re selling someone else the right to buy your stock. If the option goes in-the-money and they exercise their right, you have to sell, even if you didn’t want to.
| | | • | | Selling a Put: You’re agreeing to buy stock from someone else if they want to sell. If the stock falls below the strike price, you have to buy it, even if the price is dropping. |
Covered Calls vs. Naked Puts
There are two key types of strategies we need to cover:
| | • | | Covered Call: You sell a call option on a stock you already own. This strategy lets you collect premium (cash) while holding the stock. If the price stays below the strike, the call expires worthless, and you keep the premium. If the price goes above the strike, the seller will exercise their right to buy the stock from you at the strike price. (even if the stock has continued rising)
| | | • | | Naked Put: You sell a put and you’re agreeing to buy the stock if it drops. If the stock price falls too far, you could end up owning shares of a stock at a higher price than it’s worth. |
Now that we’ve covered the basics, you can see that options trading isn’t as complicated as it seems.
— Geof Smith
P.S. My fellow trader, Jack Carter has a list of stocks that he sees burning up the charts in October. Click here to get the tickers!
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