Essentials
| Long Call | |
|---|---|
| Long 1 XYZ Sep 50 call @ $2.00 | |
| Total Cost | Option premium paid, $200 |
| Maximum Loss | Option premium paid, $200 |
| Maximum Profit | Unlimited |
| Short Call | |
| Short 1 XYZ Sep 50 call @ $2.00 | |
| Total Credit Received | Option premium received, $200 |
| Maximum Loss | Unlimited |
| Maximum Profit | Option premium received, $200 |
| Long Put | |
| Long 1 XYZ Sep 40 put @ $1.00 | |
| Total Cost | Option premium paid, $100 |
| Maximum Loss | Option premium paid, $100 |
| Maximum Profit | Unlimited |
| Short Put | |
| Short 1 XYZ Sep 40 put @ $1.00 | |
| Total Credit Received | Option premium received, $100 |
| Maximum Loss | Unlimited |
| Maximum Profit | Option Premium Received, $100 |
Explanation and Application
Before you can trade the more complicated option positions, it would be wise to understand their building blocks: calls and puts. Critics of option trading always point out how risky, speculative, and unnecessary options are. But what they either don't understand or point out is that options are designed to be a tool for transferring risk from one trader to another. It is imperative to understand that when buying calls or puts, the potential loss is limited to the amount paid for the calls or puts. When selling calls or puts, the potential loss is unlimited (short puts really have risk limited to their strike price, but are considered unlimited for all intents and purposes). Therefore, when you buy an option, you are limiting your risk by transferring it to whomever sold the option. When you sell an option short, you are accepting the risk from whoever bought the option. Options can offer a great deal of leverage, meaning that you can have the risk/reward exposure of a large position in stock for a relatively small amount of money.
It's important to understand that there are trade-offs in options. There are good points and bad points about every option strategy. You must isolate your speculation, i.e. precisely what do you think is going to happen to a stock and when is it going to happen? You must balance potential risk versus potential reward. Always keep in mind that in option trading, you never get anything for free.
