How to Buy Options

Options trading may seem foreign and complex to some investors. But options can be an excellent vehicle to building profits and making the most out of your speculative funds.

There are two basic strategies for trading options: calls and puts.

Buying Call Options

You buy a call option if you are bullish on a stock, and you want more leverage than simply buying shares of a stock. When you buy an option, you have the right to exercise or sell it any time before expiration.

There are three scenarios that can play out when you buy a call option.

Scenario 1: The stock tanks. If you hold your option until expiration and it is out of the money, the option will expire worthless. You will not be able to sell the option, nor does it make sense for you to exercise the option – you can buy the shares for less money on the open market.

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Scenario 2: The stock rises, but not quickly enough. You were right that the stock's price would go up, but it isn't rising as high as you need it to. If you think that the stock price isn't going to reach the strike price on your option, you should consider selling it.

You may still break even or cut your losses on the option. That's because there is still time left on the option, and there may be somebody out there who wants to buy your option.

Remember, with options you'll never lose more than your initial investment and commissions. But, it sometimes makes sense to take a smaller loss on the trade.

Scenario 3: The stock skyrockets. You can do one of two things with your "in the money" option.

2) Sell the option. Before the option expires, you can sell the option. You wouldn't have to go through the hassle of taking delivery of the shares and selling them on the market, you'd just trade the option to another buyer.

Like stocks, your profit potential is unlimited when you buy call options. That's because stocks can rise to infinity. But, as we've said, with options, you can only lose what you invest in the option plus commissions.

Buying Put Options

You buy a put option if you are bearish on a stock. As the stock declines in value, the value of that put increases.

Check out the scenarios and their potential outcomes for buying put options.

Scenario 1: The stock tanks. In the case of a put option, that's great! Your put options are in the money, and you'd likely take profits now, rather than hold until expiration.

When options have intrinsic value (the amount by which the stock price is below the strike price of a put), you can sell the option for a profit. Plus, because they haven't expired yet, the options also have time value (remember that options are wasting assets, as time goes on, they lose value).

Scenario 2: The stock falls, but not quickly enough. The option may still have some value, but time is running out. You may consider holding onto the options in hopes that the stock will fall quickly in the coming days you have left. Or, you may consider cutting your losses or breaking even on the trade.

In this case, you were right in believing the stock would decline in price. But the investment didn't result in a profit because the price drop was small and gradual.

Scenario 3: The stock skyrockets. You were wrong, and the stock rose instead of fell. Your put options expire without value. But, your loss is limited to your original investment plus commissions.

Whether puts or calls, when you purchase an option, your risk is limited to the price of the option and commissions. Limited risk and unlimited profit potential make options an excellent investment vehicle for some investors.

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