Here's How Much Money You'll Makehttp://www.fool.com/investing/general/2009/12/09/heres-how-much-money-youll-make.aspx Jim Gillies
December 9, 2009
The world of options has dozens of strategies to complement your stock investment positions. So which strategy is best for you? That's a subject far broader than this simple article can tackle in its entirety, but we can start with some basics.
By now, you'll be familiar with the two basic option types (calls and puts). You should also recall that there are always two sides to a transaction -- the buyer and seller -- each of whom will be seeking to do specific things with their positions. Now, let's try to tie these concepts together and lay out the profit and losses from four basic option strategies.
Strategy 1: The long (buy) call
You can pick up a call option for $4.30, giving you the right to buy the purveyor of KFC, Pizza Hut, and Taco Bell for $35 until the third week of January 2012. That means you'd pay $430 (remember that options are sold in contracts for 100 shares) for that right. How much do you stand to gain -- or lose?
The loss part is easy. No matter how far Yum! falls between today and expiry, our risk of loss on the calls is capped at the $430 per contract we're investing. If the market gets crushed, there's blood in the streets, dogs and cats are marrying each other, and Yum! heads for $20 -- no problem. A bad situation, perhaps, for those who simply buy the shares outright and would prospectively sit on a near-$1,500 loss (per hundred shares), but less bitter for a call buyer.
On the other hand, there's (theoretically) no limit to how high Yum! can rise before expiry. And any rise in the stock price will be paralleled with a rise in the price of the call:
Note that, though the call strikes at $35, the option buyer doesn't actually make a profit until the stock goes above $39.30 (the cost of the option plus the strike price). Also note that if the option expires when the stock price is between the break-even price and the strike price, the option buyer is still better off exercising, since some of the loss taken on the initial call buy can be recouped.
Strategy 2: The long (buy) put
The January 2011 $25 strike puts currently tip the scales at $4.45. So if "Buffett's favorite bank" continues to shrug off the financial malaise and heads (and stays) north of $25 by expiration, our maximum loss per contract is $445. Our maximum profit would occur if Wells went bankrupt before our option expiry (don't hold your breath) and the stock went to zero.
Strategy 3: The short (sell) call
Consider the damage you could have inflicted on yourself if you'd decided that rapid riser SXC Health Solutions (Nasdaq: SXCI ) was overvalued earlier this year at $25 and sold calls against it (it's over $50 now), or if you'd sold calls earlier this year, when it looked like General Electric's (NYSE: GE ) finance division might do it in (big, stodgy GE has nearly tripled since).
It's arguably for that reason that selling calls as a stand-alone trade is termed "being naked" -- as in, that's how you feel if the stock doesn't cooperate and keeps going up. Still, if you felt that Bank of Nova Scotia (NYSE: BNS ) , flirting with its 52-week high, had suitably weathered the financial storm and was unlikely to continue its meteoric recovery, you could sell a March $50 call for $1.25 and hope for the best.
Those who go short calls are generally down on the stock's prospects, at