Question

Discuss how stock options work and the difference between a put and a call.

Are there any additional risks involved when trading options?

After doing research you expect profit and stock price to fall in the near future at The Purple Grape wine company because of bad weather during the grape growing season. How would you as an investor try to profit from this with options?

Pick two of the four choices below and explain your reasoning.

Buy a call

Sell a call

Buy a put

Sell a put

Answer 1

Stock options are derivative contracts which means that they derive their value from an underlying asset.

Stock options give the buyer the right to either buy or sell the underlying at a particular price on a pre-specified date and for this he pays a premium. On the other hand, the seller has the obligation to either buy or sell the underlying at a particular price on a pre-specified date if the buyer exercise his right and for this he receives the premium from the buyer. The buyer is called the holder and the seller is called the writer.

Stock options work on cash settlement basis. Cash settlement means that there is no actual transfer of the underlying, only the difference between the strike price and the market price, which is also called as payoff of the options is paid or collected from the parties involved.

There is only one small difference between call and put. In Call option, the holder has the right to buy the underlying and the writer has the obligation to sell if buyer exercise the right. But in Put option, it is completely reverse, the holder has the right to sell and the writer has the obligation to buy if the buyer exercise the right. The call option is exercised by the holder when the spot market price of the underlying is greater than the strike price, and put option is exercised by the holder when the spot market price of the underlying is less than the strike price.

There are additional risks involved in stock options. The major risk is for the writer of the option, if the price goes against the expectations then the losses are unlimited. Options are very time sensitive and are for short terms only. Cost of trading the options is always a major factor.

If you expect the price to fall in near future then the investor can earn profits from options by 2 different ways:

1. Sell a call option: This will lead to immediate benefit of the premium received as you expect that the price will go down and if the spot price is less than the strike price, the holder will not exercise and he will have a net gain of the premium received.

2. Buy a put option: If the spot price is less than the strike price the holder i.e, the investor will exercise the put option as he can sell the underlying at a higher price than the spot price. The net gain in this case will be the difference between the strike price and the spot price t expiry.