Option Examples

Example One - Basic Call

You did your research on Apple and decided that the stock price will increase dramatically soon. You want to invest approximately $2000, but the stock is very expensive (currently trading at $121.51). Your $2000 will only buy you about 16 shares. You want more leverage. So you look into options for Apple. You find that the May $125 Strike Price Call Option will cost you $470 per option (stated as $4.70). You stretch it a little and buy 5 option contracts costing you $2350. Sure thing the next day, Apple shares jump up to $126.17. You look at your option and its now worth $5.65.

Do some quick math and your profit is $475. That is, 5 contracts * ($565 - $470). Now if you had bought the stock directly, your profit would have been around $88 because remember that $2350 would have only bought you 19 shares. That is the power of options...if you get it right!

Security	Cost	Profit
AAPL stock	$121.51 * 19 = $2,308.69	($126.17 * 19) - $2,308.69 = $88.54
AAPL option	$470 * 5 = $2,350	($565 * 5) - $2,350 = $475

This example shows a really nice profit. But remember that you could have easily lost $475 if Apple did not perform well. If you had bought the stock, you would have lost only $88.54 and you would have the luxury of holding onto the stock and wait for it to appreciate. With options, you don't have the luxury of time.

By the way, I did not make up these numbers. This is how the it was on April 23rd, 2008.

Example Two - Basic Put

You have a fairly bearish sentiment on a liquid tech stock—we'll use AMD as a teaching ticker (the dollars below are a simplified example, not a live quote). AMD is currently trading around $120 so you go ahead and buy some put options. You scan the option table and decide to pick the near-term Put where the strike price is $115. It costs you $4.50 per contract (remember that you have to multiply by 100 to find out what you will actually pay from your pocket!). Because it's only $4.50 you purchase 5 contracts. So your cost is $2,250 plus any commissions or fees.

The next day you find out how lucky you are (or smart you are depending on how you want to look at it). The company reports terrible earnings and the stock price dips to $105! You hate to see the company do badly but you love to make money. Your option is now worth about $11.00. I'm sure you can do the math by now. Your net profit is roughly $3,250 before fees. Not bad—but remember the same leverage works against you when the stock rises or when implied volatility collapses.

Security	Cost	Profit
AMD stock (short 100 shares for comparison)	$120 * 100 = $12,000 notional	$12,000 - ($105 * 100) = $1,500
AMD put options (5 contracts)	$450 * 5 = $2,250	($1,100 * 5) - $2,250 = $3,250

For comparison purposes, I've assumed you shorted 100 shares. So the first row in the table shows what the profit would have been if you closed that short at $105/share.

Example Three - Call gone wrong

You got a nice tip about a little-known, low-priced company poised for a big bounce. The ticker is thinly traded. You buy some call options where the strike price is $7.50. You buy it at $0.45 (again multiply by 100 to get $45). So you sit and wait for the thunder to come rolling in.

You soon discover that your tip was bad. The stock is not behaving as expected...in fact it is declining in stock price! you put in your sell order for the options but you can't sell them easily. Why? Because the volume is near zero and the bid/ask is a canyon! Somebody sold you a bum option when the sentiment was high. But now nobody likes it and nobody is willing to take those options off your hands at a fair price. You're stuck!

But wait; you still have some time before expiration. Maybe the stock will pick up and people will start trading in these options again. Maybe...and maybe not. This is the risk you sometimes take when dealing with options. I suggest you stick to the ones where the volume and open interest are healthy and the bid/ask spread is tight, so you have a reasonable chance of getting out if you want.