In this article, experienced investor Daniel Calugar examines how a variety of options work when trading stocks. He explores situations in which investors could increase their yields or reduce their risk compared to resting limit orders.
A resting limit, or limit order, is a stipulation used by traders to control the prices at which they trade. Simply put, a buy limit order is an instruction to purchase a stock when it reaches a specific price. A sell limit order is the opposite – an instruction to sell when a price reaches a certain price.
A put option is a contract that provides the right, but not the obligation, to sell a stipulated amount of an asset at a predetermined price, called the strike price, within a specified time frame. The purchase of a put option is indicative of a negative outlook about the future value of the underlying asset. Put options are traded on stocks, currencies, bonds, commodities, futures, and indexes.
For example, suppose you bought a put option on Apple (NASDAQ: AAPL) stock at a strike price of $115 per share because you expect the stock price to go down in six months. In that case, you could make a profit by exercising your put option and selling those shares at that higher price if the market price of the stock goes down like you suspected it would.
A put option can be contrasted with a call option, commonly referred to as a “call.” A call option gives the holder the right to buy the underlying asset at a predetermined price, either on or before the expiration date of the options contract. Unlike a put option, a call buyer profits when the underlying asset increases in price.
Using our example above, if you bought a call option on Apple (NASDAQ: AAPL) stock at a strike price of $115 per share because you expect the stock to go up in six months, you could make a profit, if you are correct, by exercising your call option to buy the stock at $115 per share regardless of the current price.
Resting limit orders provide a trader with an element of control, but the filling of the order is not guaranteed even if the limit price is reached. This puts the entire value of the stock at risk until the order is filled. On the other hand, options are the purchase of a guaranteed price at which the trader can purchase or sell. There is a cost for this guarantee, and that must be factored into the overall strategy.
About Daniel Calugar
Daniel Calugar is a data-driven investor with an academic and professional background in computer science, business, and law. He developed a passion for investing due to frequent interaction with investment professionals who serviced his legal clients’ investment needs. As a tax partner at the Atlanta law firm of Hansell & Post and the global law firm of Jones Day, he incorporated his partnership interest to set up and serve as trustee for his tax-qualified profit-sharing plan. Calugar utilized his technical skill set to design computer programs that would help him make more effective investment decisions. When Dan is not working, he enjoys spending time working out and being with friends and family. As a pilot with over 2000 hours of single-pilot experience flying business jets, he enjoys flying volunteer flights for Angel Flight.