Long stock is the most common position among investors. After analyzing
the fundamentals of a company and deducing that the company's product,
its revenue model, and current market conditions reflect the likelihood
of positive growth, the retail investor purchases the stock as an
investment in that company: Over a period oftime, ifthe investor's analysis
proves correct, the stock value increases-rendering a profit. In this
case, the investor who purchases stock with his or her own capital is said
to be long stock.
Here is an example. An investor who has no position in XYZ purchases
100 shares ofXYZ at $50 per share. The investor is now long 100
shares ofXYZ. Figure 3-1 shows the profit and loss associated with the
outright ownership of stock.
The profit in this case is unlimited. This position will profit as the
stock increases in value. Each $1 increase in the market price ofthe stock
will result in $100 worth of profit.
The loss in this example is limited. This position will generate a loss
as the stock declines in price. The risk is limited only because the stock
can only decrease to zero. Each $1 decrease in the market price of the
stock will result in $100 worth ofloss.
Short Stock
Being long stock is a bullish strategy, meaning that you believe there will
be a rise in the market price. What if the stock is not performing positively;
however? What if it is declining in price? Or, what if the investor
believes that the stock is highly overvalued and is ready for a significant
price pullback? Is the investor simply out of luck?
Stock that is in a downward trend (decreasing in value) is referred to
as behaving bearishly. Similarly, an investor who has a pessimistic outlook
on a stock is referred to as being bearish. The bearish trader can take
advantage of an anticipated declining market by selling a stock short. In
other words, he or she will sell a stock that he or she does not currently
own. In this case, the brokerage firm lends the investor a certain number
of stock shares at a particular price under the condition that the investor
has capital in his or her account in order to cover the cost of the stock
being borrowed. With the stock in hand, the investor now has the ability
to capitalize off what he or she is speculating to be a downward move in
the stock. The investor sells the borrowed stock in the marketplace at its
existing price and waits until the price decreases. Once the stock price
declines, the investor buys the stock back in the open market at the lower
price. He or she is then able to return the stock to the brokerage firm
while capturing the profit. To be sure, by selling stock short, a retail
iIlvestor can take advantage of a declining market. There is always a risk
that the stock that has been sold short will increase in price, however.
This situation could force the investor to purchase the stock back at a
higher price, resulting in a loss. If the investor is correct, however, the
stock will decrease in price and he or she can buy the stock back from the
open market in order to capture profit.
Here is an example. An investor who has no position in XYZ borrows
100 shares from his broker and sells it for $50 per share. Figure 3-2 shows
the profits and losses associated with the short sale of a security. In this
case, the profit is limited to the amount collected for the stock and risk is
unlimited.
The profit in this situation is limited. This position will profit as the
stock declines in value. Each $1 decrease in the market price ofthe stock
will result in $100 worth of profit.
The loss in this case is unlimited. This position will lose money as the
stock rises in value. Each $1 increase in the market price ofthe stock will
result in $100 worth of loss. There is also the risk of stock being
demanded back by the brokerage firm.
Long Call
The buyer (holder) of a call has as much profit potential as the owner of
the underlying stock but has significantly limited the risk ofloss. Because
of the limited capital used in controlling a large interest, the long call
position is a leveraged position. The risk involved is the total amount paid
for the call.
A long call position is used when the trader is bullish on the underlying
security and is an alternative to long stock.
Here is an example. XYZ stock is trading at $50 per share, and the XYZ
July 50 call is trading at $2.An investor purchases one XYZ July 50 call for
$200. Figure 3-3 shows the profits and losses associated with ownership of
a call option. The profit potential to the upside is similar to that of long
stock, whereas the risk is limited to the purchase price ofthe option.
The profit in this case is unlimited. When measured upon expiration of
the option, each $1 increase in the price ofthe stock higher than $52 ($50
strike price ofthe option plus $2 paid for the option) results in $100 worth
ofprofit. The profit from a long call will always be less than the profit from
the same amount oflong stock as represented by the option because ofthe
time premium paid for the option. In this case, the profit from long stock
would be $200 higher than the profit derived from the option.
The loss in this situation is limited to the amount paid to purchase
the option. When measured upon expiration ofthe option, if the stock is
trading at $50 or lower, the option will expire worthless-and the entire
investment in the option will be lost. There will be a partial loss if the
stock is trading between $50 and $52 upon expiration of the option.
Short Calls
The seller (writer) of a short call has as much loss potential as the short
seller of stock but faces much less potential for gain. The retail investor
will need to meet capital requirements in order to transact this position.
He or she will also need to have cash in the account in order to cover the
short call position or to own the underlying securit)T. The short call is frequently
combined with long stock. This strategy is called a covered call or
a buy-write and is covered.
Here is an example. XYZ is trading at $50 per share, and the XYZ July
50 call is trading at $2. One XYZ July 50 call is sold for $200. Figure 3-4
illustrates the risks and losses associated with the sale of a call option.
The profit potential is limited to the amount collected for the sale of the
option and the risk is unlimited.
The profit in this situation is limited. The total profit to the option
seller is the $2, or $2 X 100 = $200. When measured upon expiration of
the option, if the stock is trading at $50 or lower, the option will expire
worthless and the entire premium received is retained. There will be a
lesser gain if the stock is trading between $50 and $52 upon expiration
of the option.
The loss here is unlimited. When measured upon expiration of the
option, each $1 increase in the price of the stock higher than $52 ($50
strike price ofthe option plus the $2 received for the option) will result in
$100 worth ofloss.
Long Put
A long put position is used when the trader is bearish on the underlying
securit)T. The buyer/holder of a put carries the profit potential of a short
stock position but has a significantly limited risk of loss. There are no
margin requirements for a long put position, and the risk is the total
amount purchased for the put. Also, for those who do not trade on margin,
selling stock short is not an available option. Therefore, a long put is the
exclusive vehicle for speculating on a decline in the price of the underlying
stock.
Here is an example. XYZ is trading at $50 per share, and the XYZ July
50 put is trading at $2. One XYZ July 50 put is purchased for $200. The
profit and loss associated with the purchase of a put.
The profit potential is considered to be unlimited, although the
underlying can only go to zero, and the loss is limited to the purchase
price of the option.
The profit in this instance is limited. The profit potential of the long
put is limited only because the value of the underlying stock can only
decline to zero. When measured upon expiration of the option, each $1
decrease in the price of the stock lower than $48 ($50 strike price of the
option minus the $2 paid for the option) will result in $100 worth ofprofit.
The profit from a long put will always be less than the profit that would
have been earned by selling the same amount of stock short, covered by
the option contract due to the time premium paid for the long put.
The loss here is limited to the amount paid in order to purchase the
option. When measured upon expiration of the option, if the stock is
trading at $50 or higher, the option will expire worthless-and the entire
investment in the option will be lost. There will be a smaller loss if the
stock is trading between $48 and $50 upon expiration of the option.
Short Put
The buyer (holder) of a put has much ofthe profit potential of a short
stock position but has significantly limited the risk ofloss. No margin is
required for this position. The risk is the total amount purchased for the
put.
The seller (writer) ofa put has as much ofthe same loss potential as a long
stock position but has much less potential for gain. The retail trader or
investor is required to meet capital requirements for this transaction (in
other words, he or she will need to have cash in the account as security
against the short put). This requirement is referred to as a cash-covered
put, which is similar to a covered call (discussed in the strategy section of
this book). Cash in the account covers the short put.
Here is an example. XYZ is trading at $50 per share, and the XYZ July
50 put is trading at $2. One XYZ July 50 put is sold for $200. Figure 3-6
illustrates the profits and losses associated with the sale ofa put. As with
the outright sale of any option, the profit potential is limited to the
amount collected for the sale of the option and the risk is unlimited, or in
this case limited as the underlying can only go to zero.
The profit here is limited to the amount received upon sale of the option.
When measured upon expiration of the option, if the stock is trading
at $50 or higher, the option will expire worthless and the entire premium
received will be retained. There will be a lesser gain if the stock is trading
between $48 and $50 upon expiration of the option.
The loss here is unlimited. When measured upon expiration of the
option, each $1 decrease in the price of the stock lower than $48 ($50
strike price of the option minus the $2 received for the option) will result
in $100 worth of loss. There will be a smaller loss if the stock is trading
between $48 and $50 upon expiration of the option.
Read More: Types Of Stocks Calls
