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You won't get very far trading options without knowing the difference between a call and a put and how they work to make you money.
But if you know that an options contract allows you to buy or sell underlying shares of a stock, you're only a step away. The next thing to know is whether you want to buy a "call" option or a "put" option.
It's simple: With a call option, you have the right to buy shares. With a put, you have the right to sell shares.
In trading options, it's important to realize that you are not purchasing actual shares of the stock. You're buying the right to buy (a call) or sell (a put) rather than the stock itself.
And the benefit is that you don't need to pay nearly as much as you would for the stock. In other words, you can purchase options for 100 or 200 shares rather than 10 shares of stock.
If the unusual language, like the difference between a call and a put, seem scary, don't be put off. Options trading is a way to make huge profits at limited risk.
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A stock can take a long time to appreciate, fluctuating through the months. You might be lucky to make 10% per year on a long-term stock holding.
However, via options trading, it's possible to gain 50%, 60%, or more in a matter of days.
It is important to know the basics of options trading to make money, though. Let's go through how the differences between a call and a put work.
To begin, there are several more key terms you need to know. The first is "strike price." The strike price is the price at which you can buy or sell the shares at the expiration date.
The term "in the money" means the stock's price is favorable to the person holding the option. If you have an option to purchase a stock at a strike price of $25, for example, and it's selling for $28, you're in the money.
Conversely, "out of the money" means the share price is not favorable to the option holder. If the stock is selling for $20, your $25 strike price is out of the money.
If the share price is roughly the same as the strike price (or extremely close), you're "at the money."
A "premium" is the option's price. It's the "premium" that the buyer of an option pays for the right to buy the shares at the strike price. Premiums are higher for in-the-money options than they are for out-of-the-money ones. If the option's position improves, the premium rises so you can sell for a higher price before it expires.
Using Put and Call Options
A "call option" gives you the right to purchase shares at a specific strike price. Traders should use call options if they expect an increase in the share price between when they buy the option and the expiration date. If the share price does climb between those two dates, the option's value will rise as well, and you can sell the option for a profit.
A "put option" gives you the right to sell shares at the strike price. Traders should buy a put if they expect the share price to drop between the purchase of the option and the expiration date. In a put, if the share price does decline below the strike price, the option itself rises in value, and you can sell the option to realize a profit.
There is no way to know with absolute certainty when a stock will rise or fall. Money Morning's options trading specialist, Tom Gentile, believes that following how a stock does around earnings reporting season can be a very good strategy.
Stocks frequently move up or down when the company reports earnings. Favorable earnings, or an earnings beat, can send the stock climbing. Unfavorable news, or an earnings miss, can send it downhill.
Here's an example of using calls and puts to make money during earnings season.