This article is part of the “Understanding Options” series. The index page of the series can be found at http://www.sharetradingbyme.com/5/option-fundamentals/

Here are the main advantage of option as investment vehicle:

1. Option Can Be used as Insurance / Capital Protection

I would say this is the biggest thing about option. Let me illustrate with simple example: say you buy 1000 of Company XYZ’s stock for $25, hence your investment worth $25,000 at the time of buying. And something very terible happen and the stock is now worth only $5, meaning you loose $20,000 from this investment.

Now what if you buy the stock together with put option. Say you buy put option that give you right to sell at $25. Now, even the price is now $5, since you are guaranteed to be able to sell the stock at $25, then you will not loose that $20,000. In other word, your capital is protected.

Yes, there will be some cost involves, but that the same argument with the cost of your car insurance. The premium of insurance is charge every year regardless you make a claim or not.

But this factor is the one make sharemarket investment very unique. You cannot really buy a house and then buy an insurance that you will be guaranteed to sell at certain price, aren’t you ? Thanks to option, your investment in stock market can be “capital guaranteed” – you will not loss your capital! How good is that !

2. Option Can Be Used as Leverage.

With leverage, your investment goal can be achieved as higher speed. And option can do this leverage for you.

When you buy and hold a stock, for example that 1000 share of company XYZ above, you will want to sell it at higher price say you want to sell it when it reach $30 for $5 profit of $5000. So, your capital is $25000, you have profit of $5000 and that’s a return of 20%. Not bad return

But now, let say instead of buy stock, you buy a call option (that give you the right to buy at certain price) of XYZ at strike price of $25. It will cost you about $1 each, so you need to invest $1000. When the price reach $30, you simply exercise your option: buy at $25 and immediately sell it at $30 (current amrket price).

So, the effect is the same, you have profit of $5000 (of course less brokerage), but your capital is only $1000. So, the return is 500%. Imagine if you invest the whole $25,000 into this call option, then you make profit of $125,000. (500% return)

Yes, one thing really to consider is that option have expiry date, so if the price have not reached your price target before its expiry date, then you might loose the whole amount you invest on that option as the option could be expired worthless.

3. Option Can Be Used As Income Producing Activity

How about getting upfront income every moneth regardless of the movement of the market (because you received up-front payment already) ? Yes, this is possible with option. Instead of buying option, you can now “writing” option or selling it to other people. You become the “insurance company” discussed in point 1 above.

There are many strategy that you can apply to do option writing such as Covered Call, Naked Put, Credit Bull Put Spread, Condor, and other exotic strategy. SOme of these strategies require you not also write option also buy option to achieve specific goal.

4. Option Can be Used similar as Short Trading

Short trading is where you borrow stock from your broker, sell it now and when the price is go down, you buy from the market and return it to your broker. Basically making profit where the market down. This strategy is quite risky and highly regulated, but with option you just buy “put option” without any hassle at all.

With put option as already mention above, if the price went down from the strike price, you still have the right to sell on higher price.

By buying put option you will make profit if the price is going down, butt you are not exposed to the additional risk like Short Trading. Buying a call option and put option will carry the same risk.

But please don’t give up as yet ! Not until after reading this article. I will explain all basic and fundamental that you need to know about option in plain English as practical as possible.

This tutorial will be divided into several parts below:

• Part 1: Basic Of Options
  The basic understanding of Option including: the mechanism behind option trading, the type of an option. You need to fully understand this part before proceeding to other part.
• Part 2: Why Option is an Absolute Beauty
  Explain the crucial role and importance of option in the trading world, especially share market.
• Part 3: Around the money
  The clear explanation about ‘At The Money’, ‘In the Money’, ‘Out The Money’ and its importance
• Part 4: Transaction in Option Trading
  Explain the needed understanding before you do any option transaction in the share market.
• Part 5: The Summary of Option Fundamental
  A comparison side by side in a neat table to summarize all the basic option understanding.

On each part, there will be a multiple-choice quiz to help you check your understanding.

Note: should the link it’s not ready, please wait several days as I make some final editorial review.

1. Contract: Promise you must keep

Let us start with something simple, but it’s very important. What is a contract?

Well, contract is basically a legal promise or formal promise. The patrons of a contract promise something to each other. People break promise all the time, but if you put that promise into a contract, you cannot just break the promise without bearing the consequences.

For example: you want to buy a new car. Let say, this new car will only be available at the end of next month. You really like this car and it is your opinion that once this car is available next month, it will become such a hot car and the price might go up as too many people want it. So, you want to secure the price now. The dealer said that they will sell you the car for $30,000 if you pay 10% deposit now. Should you agreed, the dealer will ask you to sign a car sales contract outlining that they will sell the car for $30,000 next month once it become available, that you will put $3000 as deposit, and that you will pay the balance upon delivery.

Once that sales contract is signed, then you are obligated to buy that car next month and the dealer are obligated to sell it to you.

What if something happened and you decide to not go ahead with the purchase. Can you just change your mind like that without any consequences? Probably not. Maybe the dealer allows you to cancel the purchase, but they forfeited your deposit.

Now, imagine a contract like that, but it is up to you whether or not you want to proceed with your contract. That is: if you you want go ahead to purchase the car, you simply pay additional $27,000 (the balance), but if not, your deposit will be simply returned and no question asked.

Is there any contract like that ? Yes, introducing Option contract….

2. Option is Privilege.

Basically, Option is just a privilege or right. With ‘normal’ contract ,you are obligated to fulfill the contract, or otherwise face the consequences. But with option contract, you have the privilege to choose whether you want to fulfill the contract or just abandon the contract.

But in order to have this privilege, you need to pay the price. The price you need to pay to have this flexibility is referred as Option Premium or simply Premium. For example: we pay additional $1000 upfront to the car dealer as Premium to have that privilege.

When you buy an option, you buy the privilege by paying the premium. But only the privilege, not the ‘main merchandise’. In this example: $1000 premium that you pay to the car dealer only buys you the privilege to decide later whether or not to buy the car. But the car itself need separate $30,000.

In Option contract, the ‘main merchandise’ referred as “underlying asset” and could be virtually anything: share, property, warrant, future, block of land, car, etc. For example:

• Share option: the buyer and seller agrees to transact the shares at a certain price.
• Property option: the buyer and seller agrees to transact the property at a certain price.
• etc.

On the other hand, the agreed price of the underlying asset is referred as “strike price”

But a contract cannot be valid forever. It always has time limit referred as expiry date. After the expiry date has elapsed, the contract is no longer binding or simply “expired” or not valid anymore. This is also applied to option contract.

So, in the nutshell, Option Contract is simply a deal between buyer and seller where the buyer have the privilege to proceed or not to proceed the deal within certain time frame.

Now, who is the seller ? The seller is just general public. You can be a buyer now but then you can be a seller as well on other time.

Need to be very clear here that the seller is NOT the Stock Exchange or the Option Clearing House. Stock Exchange/Option Clearing House is just mediator and the umpire to make sure everybody play by the market rule.

3. Option’s Triad.

When we are talking about option, there are always 3 (three) major factors:

1. Underlying Asset: what will be transacted?
2. Strike Price : what is the agreed price?
3. Expiry Date : when the contract expired?

This triad constitutes the value of every option and it will always be defined in a option contract.

4. Option Type: Call Option and Put Option

Call Option

Call option is the right to buy an asset at certain strike price on or before certain expiry date.

If you have Call Option for Microsoft share at $30 (expired 17 Jan 2009), then you have the right (not obligation) to buy Microsoft share for $30 each as long as you do it on or before 17 Jan 2009.

Let say, today is 16 January 2009 (before expiry date) and Microsoft share’s price in the market is currently $40 each. Will you use your privilege from the call option to buy the share? Yes. Because once you buy for $30 each, you can immediately sell for $40 each and making profit $10 each share.

On the other hand, let say the price in the market is only $25. Will you use your right from the call option to buy the share ? No. Because you can buy cheaper in the market why pay the higher price.

Put Option

Put option is the right to sell an asset at certain strike price on or before certain expiry date.

If you have Put Option for Microsoft share at $30 (expired 17 Jan 2009), then you have the right (not obligation) to sell Microsoft share for $30 each as long as you do it on or before 17 Jan 2009.

Let say, today is 16 January 2009 (before expiry date) and Microsoft share’s price in the market is currently $40 each. Will you use your privilege from the put option to sell the share? No. Because it’s trading at $40 in the market, so you can sell it in the market for better price.

On the other hand, let say the price in the market is only $25. Will you use your right from the put option to sell the share ? Yes, of course! Because you cannot get $30 by selling in the market (the price is now $25), then it’s time to use the privilege from put option to sell it for $30 each.

5. Buy vs Sell, Buyer vs Seller

We know that for every transaction there will always be at least a buyer and a seller. That is: if you want to buy ’something’ (you are the buyer), there must be another party that want to sell that ’something’ (seller). Otherwise, there will be no transaction.

In other words, if it is a buy for you, it will be a sell for the other party and vice versa.

I need to emphasize this, as this is where the confusion starts. The definitions of call option and put option above are from buyer perspective.

So, if you buy a call option, you have the right to buy the asset on strike price before expiry date. And if you buy put option, you have the right to sell the asset on strike price before expiry date.

From seller perspective, if you sell a call option, you have to sell the asset on strike price only on or before expiry date should the buyer exercise his/her right. And if you sell a put option, you have to buy the asset on strike price only on or before expiry date should the buyer exercise his/her right.

Can you see know why this can be confusing ? If you start to, please stop here and try to re-read above passage until you grasp the understanding. Don’t continue if you still have any confusion, it will confuse you even more.

6. Option is Trade-able: introducing ‘Option Writer’

You are allowed to sell your option to other people. The characteristic of the option (Option Triad) will remain the same, but the premium may change.

Let take an example that you buy a call option for Microsoft share (so you can buy the share at certain price before expiry date should you decide to do so). But long before the expiry date, you already made up your mind that you will not want to buy the share. Since you will not use that privilege, probably somebody else can make use of this privilege. Then, you can simply sell your right back to the market. Now, you are no longer option- buyer, you become option-seller.

Now that you have sold your call option (where the buyer can buy the share should he decide to), what happen if the buyer wants to exercise his right? Remember, you don’t have the share, but now you sold an option that promise the share…. Where you can get the share ? The answer is: from Option Writer.

Option Writer is the first person who sell a option contract to the market.

In term of call option, call-option-writer is the one who actually own the underlying asset, ready to be sold, should the call-option-buyer decide to buy it.

In term of put option, put-option-writer is the one who actually ready to buy the underlying asset should the put-option-buyer decide to sell his/her underlying asset.

The contract within the option is always between the writer and the latest buyer.If you sell your option, the contract of the privilege will be shift from you to your buyer. Since you are not the first person who sell the option, once you sell the option, you have nothing to do with that option anymore.

7. Option is Anonymous

Contrary to popular belief, when option contract is sold , neither the option-writer nor the option-buyer knows each other. Nobody knows to whom his option is being sold to and nobody knows from who this option from.

Option is anonymous. The buyer and the seller is just a number in the market. They don’t know each other. But they are all have to obey the market rule. The term in option contract is enforceable. This is the assurance from the Stock Exchange/Clearing House as the market authority. One of many ways to ensure everybody play by the rule for example is to make it compulsory for every option writer to provide some sort of security (cash or share) as collateral among many others things.

Out-of-The-Money vs In-The-Money Covered Call

There are 2 main type of covered call that you can do: out-of-money covered call (most popular) and in-the-money covered call, which mainly determined by your view or believe what the price of stock is going to be at the end of option period.
For example: a stock is now trading at $10 and option writer buy the option at that price to do covered call. Let say 1 month covered call for $10.5 strike price will give you 50 cents premium and 1 month covered call for $9.5 strike price will give you $1.0 permium per share (the additional $0.5 is the intrinsic value of the option – the actual premium(time value)/profit will be roughly the same – in this example 50c – in reality there could be some differences depending on the market). Then:

• If at the end of option period the stock go up to $11, both $9.5 and $10.5 option will be exercised. But there will be additional 50c profit of capital gain for $10.5 option writer (from buying at $10 and selling at $10.5) . See comparison table below:
  

  Price is $11 at option expiry date
  	Price per stock
  	$9.5 strike price	$10.5 strike price
  Stock Buy Price	$10.00	$10.00
  Premium
  intrinsic value	$0.50	–
  time value	$0.50	$0.50
  Option excercised?	Yes	Yes
  Selling Price/ Excercise Price	$9.50	$10.50
  Capital Gain
  Sell:	$9.50	$10.50
  Buy:	$10.00	$10.00
  Net:	-$0.50	$0.50
  Total Premium	$1.00	$0.50
  Total Profit	$0.50	$1.00

• But if at the end of option period the stock go down to $9, both option will not be exercised, but $10.5 option writer will suffer (unrealized) loss of 50c ($1 capital loss: buy $10,  current value $9, minus 50c premium received) while the $9.5 option writer have not suffered any loss ($1 capital loss: buy $10, current value $9) minus $1 total premium. See comparison table below:
  

  Price is $9 at option expiry date
  	Price per stock
  	$9.5 strike price	$10.5 strike price
  Stock Buy Price	$10.00	$10.00
  Premium
  intrinsic value	$0.50	–
  time value	$0.50	$0.50
  Option excercised?	No	No
  Present Value	$9.00	$9.00
  Capital Gain
  Present Value:	$9.00	$9.00
  Buy:	$10.00	$10.00
  Net:	-$1.00	-$1.00
  Total Premium	$1.00	$0.50
  Total Profit	$0.00	-$0.50

Hence, in the bearish climate -or- if you believe the stock will be heading down, in -the-money covered call would be better choice as it will give more downside protection.

Covered Call and Dividend

Now what happen if during your covered call period the company is distributing dividend? As you know, the price of the stock *usually* go down on ex-dividend date to self adjust the value of dividend that being taken from the market and only if you buy a stock before the ex-date you are entitled of the dividend, hence:

If the call option is “in-the-money”

Whether or not the option is exercised- 1 day before ex-date – is determined by dividend value and the rest of time value of the option.

• So, firstly check the time value of that option (check the premium for that particular option on the market and subtract it by intrinsic value)

Example 1

For example: let say we have:

• call option with $9.5 strike price
• Current price is $10
• the dividend will be 10cents
• the option price is now 80c (say, time value 30cents + 50c intrinsic value = 80 cents) with 2 weeks to go
• Hence, ex-date price is likely about $9.9 ($10 – 10 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital gain: 40c  ($9.9 expected market value on ex date, minus $9.5 strike price)
• Dividend: 10c
• Total profit: 50c minus the buying price of option

If he/she just sell^(*) the option, profit will be 80c minus the buying price of the option.

Hence, it is unlikely that the option will be exercise since the option holder will be profitable to just sell the option back to market.

Example 2

For example: the same as Example 1 above, except:

• the dividend will be 70cents
• the option price is now 60c (say, time value 10cents + 50c intrinsic value = 60 cents) with 1 weeks to go
• Ex-date price is likely about $9.3 ($10 minus 70 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital profit: -20c  ($9.3 expected market value on ex date, minus $9.5 strike price)
• Dividend: 70c
• Total profit: 50c minus the buying price of option

If he/she just sell^(*) the option, profit will be 60c minus the buying price of the option.

Hence, it is unlikely that the option will be exercise since the option holder will be profitable to just sell the option back to market.

But as we can see, the difference between exercising and not exercising is now quite close with the diminishing of the time value of the option. If the time value is quite trivial, then there will be very little difference between exercising or not.

If this is the case, then additional motivation such as the option holder want the ownership of the stock (to vote on AGM for example) or other special offer exists, then it will be more profitable for option holder to just exercise the option.

If the option is still out of the money:

Example 3

For example: let say we have:

• call option with $9.5 strike price
• Current price is $9
• the dividend will be 10cents
• the option price is now 30c (all time value 30cents, no intrinsic value) with 2 weeks to go
• Hence, ex-date price is likely about $8.9 ($9 – 10 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital loss: -60c  ($8.9 expected market value on ex date, minus $9.5 strike price)
• Dividend: 10c
• Total loss: 50c plus the buying price of option

If he/she just sell^(*) the option, profit will be 30c minus the buying price of the option.

Hence, it is very unlikely that the option will be exercised.

Example 4

For example: the same as Example 3 above, except:

• the dividend will be 70cents
• the call option price is now 10c (time value 10cents, no intrinsic value) with 1 weeks to go
• Ex-date price is likely about $8.3 ($9 minus 70 cents)

If he/she exercises the option on 1 day before ex-date and sell it immediately on ex-date:

• Capital loss: $1.2  ($8.3 expected market value on ex date, minus $9.5 strike price)
• Dividend: 70c
• Total loss: 50c plus the buying price of option

If he/she just sell^(*) the option, profit will be 60c minus the buying price of the option.

Hence, it is also very unlikely that the option will be exercised .

Note: (*) option need to be sold 1 day before ex date (on the decision day whether to exercise the option or just sell the option) before the price adjusted due to ex-dividend price behavior

Conclusion

If dividend is distributed in the middle of option period:

1. For out-of-the-money call option: the option will not be exercised
2. For in-the-money call option, if there is no special circumstances, option will not be exercised as well as it is more profitable for option holder to just sell the option to the market.
3. But if the motivation of the option holder is to own the stock , additionally the time value is not that significant and the profit from capital gain/dividend is not trivial (compare to the time value), then the in-the-money call option will be exercised before ex-date.

The next sentence will look like those scams : “If you want extra money – monthly, passive income – with very little effort, then this is for you“. But it’s not scam, it’s legal stock-market-related trade for public (means everybody can do it ). If you have stock / share investment, you should have this monthly income already, if you have not – keep reading.

How big is the money? It’s not spectacular, but typically it will be around 2% to 4% monthly [1. the result may vary depends on the market but this is the typical result] – or more than 24% annually (can your saving produce this? maybe not)

Before we continue, we you are really new about ‘option’, please read this quick introduction about option.

The Mechanics

Profit Loss Chart for Covered Call

This is how it works:

1. You buy stock of a company from share market (the minimum quantity could be different each country, for example, in US the minimum is 100, but in Australia the minimum is 1000 – some companies have weird number for example 1014, but this number can be easily found)
2. You sell [2. the more correct term is to 'write' rather than sell, to avoid confusion with simply buying and selling option] option contract and back it by that particular stock. The option that you write is call option, in particular option that will expire next month. The proceed of this sale is your income. It’s upfront cash as your income and practically you don’t need to do much until next month.
   The strike price of this option should be higher than the current price (This is call ‘out of the money’ option. As you know, if someone buy a call option, that someone will have the right to buy on that strike price. You are the one who sell that stock for the buyer.

From the Profit Loss Chart above (read this PLC article if you are not familiar with it) you can see the characteristic of this strategy. When we start, we already in profit. Then you will have maximum profit if the price move up a bit, but the profit will not go up beyond your strike price.

For example:

1. You buy 1000 stock of a company that trade at $10 for $10,000.
2. Then you write a call option with strike price of $10.5 for next month with premium 30c each, so with 1 contract of option require 1000 share, you will get 1000 x 30c = $300. This is your monthly income.
3. After a month, at the expiry of the option, 3 things can be happening:

• The price go up above your strike price (above $10.5): say the price go up to $11. Then the buyer of your option will exercise the option (he/she can buy for $10.5 although the price is $11 now – that’s the reason they buy the option at the first place).But because of this, you actually have additional profit (buy $10, sell $10.5 ==> additional 50c x $1000 = $500 for your pocket – that’s why the strike price should be higher than the price when you write the option / out the money call.Then you simply repeat the whole process from the start again for next month option.
• The price go down below $10: the buyer will not exercise the option (why they want to buy at $10.5 when they can buy cheaper i.e: below $10 directly from the market), the option expired worthless and the value of your option is decreasing. Say the price goes to $9 then now the value of yout stock is only $9000.But this loss is only on paper because you don’t need to sell the stock (if you sell the stock then you make the loss a reality), what you do just write another call option for next month.Remember, if you don’t do this strategy and just hold the stock, if the price go won, you will have the exact on paper loss (losing value of the stock). By using this strategy actually because you have pocketed $300 in advance (from the premium), you may considered that that $1000 loss (price go down from $10 to $9) is offset by that premium. So, if you sell the stock (realized your loss) now, without this strategy you loss $1000, but by using this strategy you loss is partially covered and total loss will only be $700. ($1000 – $300) – Again you don’t need to sell as you can just write another call option.
• The price stay around $10 to $10.5: nothing will happen. You have pocketed your premium upfront and you will simply just do it again for the next month.

As you can see on above example, with $10000 you can derived $300 monthly (3%), if you want some more just multiply your capital, i.e: with $100,000 you can expect $3,000 monthly, and so on.

The Money

So, there are 3 different ways you have some profit from this strategy:

1. The monthly premium from writing call option (around 2-4% per month of your capital)
2. Dividend (you still received the dividend if the company distribute one, just like the rest of other stock holder)
3. Capital Gain (from the increase in price of the stock)

The Disadvantage

There are some factor that you need to know before using this strategy:

1. The Capital gain is capped at the strike price. For example, if the price on example above shoout to $12 from $10 (increase by $2), you only have 50c (from $10 to your strike price $10.5) profit. Still profitable but in this case you better off without this strategy.
2. You still need to have 100% capital to buy the stock. (You may reduce this by using margin lending, though)

Better Execution / Alternative

There are some better execution to improve this strategy:

• Use margin lending to leverage your position
• If you want to protect against downturn, you also can buy put option as protection. Although your monthly profit can be easily halved if you choose to have insurance/protection using put option.

Others

• Technically, this Covered Call strategy is ‘non-directional’ meaning no matte the market go up , down or sideways, you still received the premium upfront. But I will be more comfortable calling it “almost non-directional” because the fact that if the market go down, we still need to carry the risk that the stock can be sold lower than the buying price (making loss). But again that loss is on paper, so if you just continue to do it for the next month, then the loss will never be realized.
• Why called “Share Renting”? The fact that the writer of the option have monthly income without have to sell the stock and can keep doing it month after month, this can be explained much easier if we make analogy from property market about renting.  ‘Renting’ the share implied that the share is still ours (unless the option is exercised) and whoever rent it have to pay the rent (i.e: premium) to use it for a month.

As usual, if you have question or something to clarify, feel free to ask your question on the comment box below!

Remember in share market related trading (including option trading), if the price go up it does not mean that you always make money. All depends on the strategy. Some strategy requires the price to go down in order to make profit. Other strategy will produce profit if the price goes up.  Another strategy make you money only if the price stays the same. Because of this, the Profit Loss Chart (PLC) become very useful tools. Let’s have a look more detail.

The PLC Chart

On the left is a graph that contains a PLC. The vertical line/axis on the left represents the profit (or loss) – it’s a profit if it’s above zero, it’s a loss when below zero. The zero is where the horizontal line intersects.

The horizontal line/axis represents price. Go to the left is lower price. Go to the right is higher price.

The notch on the horizontal line is initial price (the price when we start do the trading)

The blue line is the Profit Loss Chart/PLC itself.

Let see a little bit more detail about the graph and how we interpreted it into an elegant understanding.

• The green area is profit area
• The red area is loss area
• The starting price is $20
• The breakeven is on $25
• If the price at $30 there will be profit of $200
• If the price is less than $20 there is constant loss of $100
• So, when we start at $20, we immediately at loss position ($100 loss). That ‘loss’ is due to the capital cost (buying the option), brokerage cost, or other cost.
• If the price keep going down, luckily, we don’t make additional loss (the blue line on the left of $20 is on loss area)
• If the price going up from $20 to $25, we are getting to the break even point
• Only if the price is higher than $25, we are on profitable area. If it’s $30 then it’s $200 profit.
• So, from all of those point we can conclude that this kind of trading is bullish, meaning it needs the price to go up in order to make money, but it’s protected from the downturn (not making any more loss)
• This PLC is real one. It’s the PLC for buying call option.

So, just by looking this simple picture, a lot can be derived from it.

More Examples

Let see some more examples:

• When we start, immediately we are in profit already. (This will be refered as ‘credit’ strategy – since it start with some credit (money) in the pocket).
• If the price go up, it will give some additional profit only until certain price and it will go flat (no more additional profit.
• If the price go down, it will go down proportionally with the price
• So this strategy need the price to go higher just a bit to maximize the process, but we will make a loss if the price go down
• This is a strategy named “Buy Write” (or also known as “Covered Call” or “Share Renting”)

• When we start, we slightly in a bit of loss. (This could be due to some brokerage cost or other cost)
• If the price go up the profit also go up proportionally
• If the price go down the profit also go down proportionally
• We will reach break even point if the price just go up a little
• So this strategy need the price to go higher (bullish strategy) in order to make profit/
• This is the PLC for normal stock trading

• When we start, we are at the peak of our loss
• The profit go up when the price go up
• Also , the profit go up when the price godown
• In other word, as long as the price move from the starting point, doesn’t matter go up or down, we will start making progress toward profit. We just want the market to move the price. Usually this is good for a volatile market
• This is the strategy call “Straddle”. This strategy involves buying both put option and call option at the same strike price.

• When we start we are at the maximum profit.
• If the price go down, the loss will increase as well but it will be capped (no more loss after reach certain loss)
• If the price go up, it will not change any profit
• The break even is reached if the price go down a little bit.
• So this strategy also require the market to go up in order to maintain the profit (bullish strategy)
• This is a strategy called “Credit Bull Put Spread”. This involves writing put option near or at the money and buying another put option further out of the money.

• When we start, we are at the peak of our loss. This is due to cost that incurred at the start of the trading, including brokerage cost and the capital itself.
• If the price go up, the loss stays the same (increase in price will not putting more loss)
• If the price go down, the profit is increasing proportionally with the price
• The break even is also reached if the price go down a little bit.
• So, this strategy requiring the market to go down in order to make profit (bearish strategy)
• This is PLC for buying put option

Conclusion

The Profit Loss Chart is handy tool to see whether a strategy is requiring a down market, up market or neutral market. It can show elegantly where the maximum profit is, when we start losing money as well as the break even point.

To fully understand why option behaves like described below, you need to fully understands how options works. That’s quite a huge task to be covered in this article. This article just want to show you a quick to the point mechanism how option can produces profit for traders.

Call Option and Put Option

Basically, there are 2 kind of option: call option and put option.

1. If you buy a call option, you have a right to buy the underlying asset at predetermined price before certain date.
2. If you buy a put option, you have the right to sell the underlying asset at predetermined price before certain date.

Since it is only a ‘right’ then you don’t have to actually buy or sell the underlying asset. It’s totally up to you.

The Option Triad

The ‘predetermined price’ is also known as strike price and the ‘certain date’ is called ‘Expiry Date’. For example:

• a call option of Microsoft share with strike price of $25 and Expiry date of 15 June means you have the right to buy Microsoft stock at $25 each on or before 15 June. (Imagine if today is 14 June and the price of the stock is $30 each, then holding such call option will be very profitable isn’t it ?)
• a put option of Microsoft share with strike price of $25 and Expiry Date 15 September means you have the right to sell Microsoft stock at $25 each on or before 15 September. (Imagine if today is 14 September and the price of the stock is only $20, then holding such put option will be very profitable, isn’t it ?)

Profit as Option Buyer

First way to profit from option is as option buyer (or also known as option holder):

1. The price of Call Option will go up if the price of the underlying asset go up. And if the price of underlying asset go down, the price of call option also become cheaper.
   For example: if you think stock of Microsoft will go up next month (based of your analysis or tips or gut feeling..), then you can buy call option. If indeed the price of Microsoft stock is going up, then you make profit.
2. The price of Put Option will go up if the price of the underlying asset go down. And if the price of underlying asset go up, the price of put option also become cheaper.
   For example: if you think stock of Microsoft will go down next month , then you can buy put option. If indeed the price of Microsoft stock is going down, then you make profit.

To remember which option to buy if the price go up or down, just remember this phrase: CALL up PUT down (You buy CALL option if you want the price to go up, and buy the PUT option if you expect the price to go down)

Profit as Option Seller/Writer

The seller of the option also know as ‘Option Writer‘. As option writer the profit come from the price of the option when buyer make the transaction this price will be referred as ‘option premium‘. Since the buyer pay the price up front, then it does not matter where the price of the asset will go, the option writer will still pocketing that upfront payment.

But an option writer will require more trading capital and carries more responsibility  or risk than the buyer. Remember, the buyer of call option have the right to buy the asset, then as the seller/writer then he/she will have to sell the asset on that predetermined price. The same mechanism also apply put option.

Hence option trading as seller / writer is considered quite advanced. There will be many strategies that can be used to make sure option writer have real undirectional income from option trading or at least minimize their risk.

Conclusion

• There are 2 kind of options: call option and put option.
• Underlying Asset, Strike Price and Expiry Date are the main parameter of option
• Using option, Trader can make profit as a buyer, as a seller / writer, or even combination of both.