How I Made 16% On A Stock That Went Down 9% Without A Margin Account: Part 1 of 3

Most of the time I usually blog about long plays; stocks which meet my pre-set criteria and I believe will go up the next day. An investor could also take the opposite position and make money by shorting stocks that he/she believes will go down. Many novice investors may only comprehend these two ways of making money on stocks. My next series of posts will eventually establish several ways to make money without knowing the direction of the stock.

An option is a financial instrument that allows the investor the right to buy or sell the matching stock in the future at a given price. As a bullish option purchaser (I feel the stock is going to go up in the coming weeks), I have the right to buy a stock in several weeks at the price specified by the option today. It is important to establish several terms:

Strike Price (K): The transaction price available to the option purchaser in the future

Call Option (C): The right to buy the security at the strike price today, sometime in the future

Put Option (P): The right to sell the security at the strike price today, sometime in the future

So let's do a quick example using this terminology...

Let's say K = $50, C= $2, P = $1.

- A bullish investor has the right to buy the stock in the future at $50 for a premium of $2. If the stock in the future is $53, the investor would exercise his/her right to buy the stock for the strike price of $50 for the call option premium of $2, making a profit of $1. If the stock in the future is $47, the investor would not exercise his/her right to buy the stock because his strike price was $50; this investor would simply lose his/her $2.

- A bearish investor has the right to sell the stock in the future at $50 for a premium of $1. If the stock in the future is $53, the investor would not exercise his/her right to sell the stock because his/her strike was $50; this investor would simply lose his $1. If the stock in the future is $47, the investor would exercise his/her right to sell the stock for $50 at a $1 premium, making a profit of $2.

Some final notes about purchasing options:

Options are a zero sum game. There is always a winner and loser when trading options (unlike stocks were everyone can be a winner). When purchasing an option, you are betting the option writer that the stock will go higher (or lower) in excess of the price of the option premium. Sometimes you are right and sometimes you are wrong.