Let Me Present You With Your Options…
Dear Penny Stock Millionaire,
A put option is, simply “put” (pun intended), a way to bet that a stock will drop in value while limiting your risk.
Once you’ve been in the market for a while, you’ll likely start to hear new terms. You may find yourself asking, “what’s a call” or “what the heck is a put option?”
Don’t worry if you don’t know … not many people outside of the markets understand these complex trades.
Today, I’ll explain what a put option is.
Options are a way for traders to make bets on what they think the underlying stock will do in the future.
For today’s purposes, I’ll limit the discussion to stock put options to keep it simple.
Full disclosure: I don’t trade or teach options. I’m a penny stock trader and educator. But I think it’s worth reviewing so you better understand the overall markets. Let’s dive in.
What Is Options Trading?
If trading stocks is checkers, trading options is 3D chess. Options provide more complex ways to profit and hedge (limit your risk) your bets.
Unlike the S&P 500 which trends higher over time, options become less valuable over time. As they come closer to their expiration date, they “decay.” So you only have the potential to turn a profit when the option is traded.
You can’t buy and hold options, expecting they’ll rise in value over time. They literally have an expiration date.
Options typically aren’t good for day trading. either. The value doesn’t move unless the stock price moves. Now, let’s get into the details…
What Is a Put Option?
A put option is a contract between a buyer and a seller to transact at a certain price, known as the strike. The contract is good until the expiration date. After the expiration date, the contract ends and the buyer and seller owe each other nothing.
The example below is from Tesla Inc. (NASDAQ: TSLA) and shows a strike and expiration. These are key components of options contracts.
The strike is the agreed-upon price at which the seller of the option contract must buy the stock from the buyer of the put option contract. The seller of the contract becomes the buyer of the stock.
The expiration is the last day the buyer of the contract can exercise the right to sell the stock at the strike price. The buyer of the option is under no obligation to actually sell the stock short.
In the example above, let’s say I bought the option with a strike of $355. If the price of the stock was to fall to $345 on or before December 20, 2019, I can exercise my right to sell short the stock for $355 to the seller of the option contract.
I could then go onto the open market and buy back the stock for $345. Or I could hold the stock in hopes of a further decline. Once I cover my position, I keep the difference as profit.
The Difference Between Call and Put Options
Calls and puts trade the same, but they take the opposite side. The difference between call and put options is the direction in which the buyer thinks the stock will move.
With a call option, the buyer’s betting the stock will go up. A put option is the opposite — the buyer thinks the stock will go down.
In both cases, as a buyer, your risk is limited to the premium you pay when you buy the contract.
The difference lies in what you expect the stock to do. If you expect the stock’s price to fall, you can buy put options and make money if you’re right. If you expect a stock’s price to increase, and if you’re right, you can profit.
As a buyer, the premium you pay for the contract is your maximum risk — no matter what the stock does.
How Do Put Options Work?
So far, we’ve talked about the overview of what options are and how you can profit from them. The actual execution is more complex.
The above chart of TSLA options prices shows the price for one share. But options contracts trade in lots of 100 shares each. That’s important to remember… Buying options is very different from buying stocks.
When you’re trading, you can find a stock for $5 per share. You can place an order for one share for $5, or 100 shares for $500, and so on.
When buying options, if the premium is $5, you buy one contract of 100 shares for $500. Every time you see an option contract premium, you must multiply by 100 to get the price you actually pay.
The contract seller always keeps the premium and always starts off in the lead. The buyer always starts out in the hole.
Since you pay the premium, the seller gets the cash from the transaction while waiting for the contract to expire.
Most major brokerages offer options trading, both buying and selling. They also typically charge a commission for each transaction.
The Bottom Line
If you’re serious about being a trader long term, you are going to hear options mentioned a lot. Even if you focus just on penny stocks like I do, it’s still good to know about as many areas of trading as you can.
I want you to be a well rounded trader, so over the next few days I’ll go deeper into options. I don’t expect you to memorize all of it, but take some notes, or bookmark this post so you can refer back to it later.
Tomorrow I’ll get into the good stuff: how you can turn a profit options trading.
Editor, Penny Stock Millionaires