Options Trading Basics: Trading as a Business Video 2 Part 3

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A call option, an option that is hoping to profit from the price increase of a stock.

Let’s take, for an example, IBM. I’m going to go to my screen for a second. I’m going to show you what an option contract is selling for, for IBM. We’ll go down here to options. We’ll take a look at the current month of options, which is May. Option contracts will fluctuate in price, and expire at a certain date.

Almost all option contracts expire on the third week of the month in which they’re being written. The May contracts will expire on the third Friday of the month of May. That is the last day that you can trade those contracts. At the close of business on the third Friday of May, you will no longer be able to trade those contracts. The contracts will expire the very next day.

Let’s take this, May of 2008, 90 strike price option. If you were to buy a call option, you would buy it at $34.80. You can also sell a contract. In other words, just like the property owner, even though you do not own the stock, the market gives you the right to sell a contract on a stock that you do not own.

You can sell that contract for $34.10. In other words, you can collect the premium, just like the option buyer who came to your property and gave you $500. You would that $34.10 on that option contract. You get to keep it, as long as the price of IBM is at $90 or below.

That’s what makes option trading so much more flexible. You can be a writer of options, and a buyer of options, at the same time. There’s all kinds of strategies that you can use in order to profit, not only from the expiration date of these options, but also from the fluctuation of the prices themselves.

Most people who are speculators in the market buy what we call “at the money” options. Right now, IBM is trading at $124.40. The closest option to that price is that $125 option. The $125 option is – right now, if you wanted to buy it, it’s $2.80.

A single contract, if you were to purchase a call option at IBM at the $125 strike price – you would pay $2.80 for one contract. However, one contract gives you the right to purchase 100 shares of IBM stock. If you were to purchase one contract… Let’s just click on that as a “buy.” We’ll toggle this down to one contract.

One contract of the $125 call option on the May expiration of IBM would cost you $280, because you are actually purchasing the right to buy not one share of IBM, but one contract = 100 shares of IBM. Whatever the price of that option is, $2.80, you would have to multiply by 100 in order to determine your exact cost.

Including your commissions, of $2.99 for one contract, your total cost is $282.95. How would you determine whether or not you would ever make a profit?

If IBM stock rose in price… Let’s say it went up $5 tomorrow. That’s a distinct possibility, because IBM does move pretty quickly, and it does sometimes move in large numbers. What would the price – how would you determine the price of the contract, of the 125 strike price?

See, if you purchase 1 contract of this May 08 $125 contract on IBM, that gives you the right to purchase IBM at $125. The premium that you’re paying, the $280 for that one option contract that gives you the right to buy 100 shares of IBM, will expire the third week of May. The third Friday of May, to be specific.

Right now, you’re purchasing the right, but not the obligation, to purchase IBM at $125. What happens if you’re right, and IBM does increase in price? Let’s say it goes all the way up to $145.

If it’s at $145, as long as it’s at $145 before the third Friday of May, you have the right to purchase the stock, 100 shares of stock, if you purchased one contract, at $125.

Cool, right? You could immediately exercise your option. All you have to do is sell your option at $125, and pocket the difference between $125 and $145, that the stock market is currently trading at.

That’s $20 of profit. However, you don’t keep all $20 of that profit. You paid $2.80 for that premium. You gave that to the seller of that option, and they get to keep that, no matter what the current price is.

So, if your stock goes from $125 to $145, that’s a $20 difference, minus the $2.80 you paid. You have actually made a profit of $17.20.

Most people don’t hold options that long. In fact, many people who are buying “at the money” options for IBM, or any other stock that has active options on it, will hold it for just a few days. What happens if IBM goes up to $130 tomorrow?

You can simply take a look at what happens to this option, if it goes $5 further in the money. All of these options in this gray-blue screen are “in the money.” That means that the options are trading at a strike price below the current price of the stock.

If IBM were going to go up $5 tomorrow, to $130, then it’s more than likely that all of these options here will shift to a higher price. In other words, that 125 will be “in the money,” the same as this 120 is now, because there is still a higher difference between the two.

Your $2.80 option will go to $6. If you wanted to try to sell it, you’d get $5.80. What’s the difference between $5.80 and $3.80? $2. That would be your profit if IBM went up tomorrow, to $130.

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