Buying a Call

■ Belief that stock will rise (bullish outlook)
■ Risk limited to premium paid
■ Unlimited maximum reward

Buying a Put

■ Belief that stock will fall (bearish outlook)
■ Risk limited to premium paid
■ Unlimited maximum reward up to the strike price less the premium paid

Writing a Call

■ Belief that stock will fall (bearish outlook)
■ Maximum reward limited to premium received
■ Risk potentially unlimited (as stock price rises)
■ Can be combined with another position to limit the risk

Writing a Put

■ Belief that stock will rise (bullish outlook)
■ Risk “unlimited” to a maximum equating to the strike price less the premium received
■ Maximum reward limited to the premium received
■ Can be combined with another position to limit the risk

Example

ABCD is trading at $28.88 on February 19, 2004.
Buy the January 2005 $27.50 strike call for $4.38.

You Pay = Call premium = $4.38
Maximum Risk = Call premium = $4.38 (Maximum risk is 100% of our total cost here)
Maximum Reward = Unlimited as the stock price rises

Breakeven Strike price + call premium
$27.50 + $4.38 = $31.88

Risk Profile

■ Maximum Risk [Put premium]
■ Maximum Reward [Put strike put premium]
■ Breakeven [Put strike put premium]

Example

ABCD is trading at $28.88 on February 19, 2004.
Buy the January 2005 $30.00 strike put for $4.38.

You Pay = Put premium = $4.38
Maximum Risk = Put premium = $4.38 (Maximum risk is 100% of our total cost here)
Maximum Reward = Strike price - put premium = $30.00 - $4.38 = $25.62
Breakeven = Strike price - put premium = $30.00 - $4.38 = $25.62

For example, to own 100 shares of a stock trading at $50 per share would cost $5,000. On the other hand, owning a $5 call option with a strike price of $50 would give you the right to buy 100 shares of the same stock at any time during the life of the option and would cost only $500. Remember that premiums are quoted on a per share basis; thus a $5 premium represents a premium payment of $5 x 100, or $500, per option contract. Let’s assume that one month after the option was purchased, the stock price has risen to $55. The gain on the stock investment is $500, or 10%. However, for the same $5 increase in the stock price, the call option premium might increase to $7, for a return of $200, or 40%.

[b][center][size=4]Limited Risk for Buyer[/size][/center][/b]Unlike other investments where the risks may have no limit, options offer a known risk to buyers. An option buyer absolutely cannot lose more than the price of the option, the premium. Because the right to buy or sell the underlying security at a specific price expires on a given date, the option will expire worthless if the conditions for profitable exercise or sale of the contract are not met by the expiration date. An uncovered option seller (sometimes referred to as the uncovered writer of an option), on the other hand, may face unlimited risk.

Assume that the price of the underlying shares was $50 at the time you bought your option and the premium you paid was $3.50 (or $350). If the price of XYZ stock climbs to $55 before your option expires and the premium rises to $5.50, you have two choices in disposing of your in-the-money option:

1) You can exercise your option and buy the underlying XYZ stock for $50 a share for a total cost of $5,350 (including the option premium) and simultaneously sell the shares on the stock market for $5,500 yielding a net profit of $150.

2) You can close out your position by selling the option contract for $550, collecting the difference between the premium received and paid, $200. In this case, you make a profit of 57% ($200/$350), whereas your profit on an outright stock purchase, given the same price movement, would be only 10%.