The simplest option position is a long call (or put) of itself. This position benefits if the price of the underlying increase (falls), and your disadvantage is limited to the loss of the issued option premium. If you buy a call-and-put option at the same time with the same strike and the same run, you have created a straddle. Stock options are z.B. Options for 100 shares of the underlying stock. Suppose a trader buys a call option contract on the ABC stock with a strike price of $25. He pays $150 for the option. On the expiry date of the option, ABC shares are sold for $35. The buyer/owner of the option exercises his right to acquire 100 shares of ABC at a price of $25 per share (the strike price of the option). It immediately sells the shares at the current market price of 35 $US per share. He paid 2500 $US for the 100 shares (25 x 100 dollars) and sold the shares for $3,500 (35 x $100). Earnings on the option are $1,000 ($3,500 – $2,500), less the $150 premium paid for the option.
As a result, its net profit excluding transaction costs is 850 $US (1,000 to 150 $US). This is a very nice return (ROI) for an investment of only 150 dollars. Now think of a sale option as an insurance policy. If you own your home, you are probably familiar with buying homeowner`s insurance. An owner buys an owner`s policy to protect his home from damage. You pay a sum called a premium for a period of time, say a year. The policy has a face value and protects the policyholder in case the house is damaged. The potential buyer would or would not benefit from the purchase option. Imagine you can buy a call option from the developer to say home $400,000 at any time in the next three years. You know this as a non-refundable down payment.
Of course, the developer would not grant such an option for free. The potential buyer must pay a down payment to guarantee this right. If an investor thinks that the price of a stock will probably go up, he can buy calls or sell put to take advantage of such a price increase. When buying call options, the investor`s overall risk is limited to the premium paid for the option. Your potential benefit is theoretically unlimited. It determines the extent to which the market price exceeds the strike price of options and the number of options selected by the investor. Imagine you wanted to buy technology stocks. But you also want to limit losses. By using put options, you can limit your downside risk and enjoy all the benefits in a cost-effective way.