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by Das Brain

Part 4 How Do I Trade Call Option Contracts?

In part 2 and part 3 of “Intro To Option Trading”, you can see that you can trade options just like stocks, which is buying low and selling high the option contracts themselves. Another term on this is called making money from the spread or the difference in the premium values.

To give a simple example or review, let’s say if you buy 1 option contract at $1.00 and sell that same option contract at $1.95. It doesn’t matter whether its an CALL or PUT option contract for this example. We’re just looking at the spread here, the difference in premium values. You’ve made some money on this trade of course because you sold the option contract higher than what you bought it at. Remember 1 option contract represent 100 shares so you sold at $1.95 X 100 = $195 and you bought at $1.00 X 100 = $100. The take home profit on this is $195 – $100 = $95 then subtract your commissions.

Buying an option contract and holding the option contract doesn’t mean you are obligated to buy or sell the underlying stock. You could very well sell the option contract and make the money from the spread or you sell it to minimize your losses. You close the position before the expiration date.. The other side of the coin is you could do nothing all the way to the expiration date and let it expire worthless (you lose what you paid for the option contracts).

Remember when you purchase an option contract it either gives you the right to buy or sell the underlying security or stock, but you as described in the last paragraph you can sell it, or let it expire. However, if you really wanted to own the underlying stock at $27, let’s say Microsoft (MSFT) then in the case of a Microsoft $27 CALL option contract expiry AUG. 2007 you can exercise that CALL option contract at the expiration date. When you exercise the contract, now you are completely obligated to buy the underlying stock which for this example is MSFT:NYSE at the strike price at expiration AUG. 2007.

If on Friday, August, 24, 2007, the price of Microsoft’s stock is at $31 and you have exercised your right to purchase 100 shares of MSFT, because you own 1 CALL option contract on MSFT with a strike price of $27 for AUG. 2007. Then what you need up front is $27 X 100 = $2700 to purchase the 100 shares of MSFT, because your CALL option contract had a $27 strike price. The seller of the $27 CALL option contract that you owned, is obligated to sell you the 100 shares at $27, even though MSFT is now trading at $31 on the market.

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At this point, you now own 100 actual shares in Microsoft corporation and you have a few choices here. You can hold on to these Microsoft shares and collect dividend income from them, or you can turn around and sell them back into the market for the current price which is $31 in this example. Remember you bought them for $27, so you can $4 a share on them. Therefore, 100 shares will gross you $400. Another alternative in addition to holding the shares and collecting dividends on the 100 shares of MSFT, is to sell option contracts for these 100 MSFT shares that you now own, I will cover this in Part 7 of this series. That is all for Part 4 today.

This entry was posted on Monday, February 12th, 2007 at 12:47 pm and is filed under Option Trading. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.