An option is a contract that gives the holder the right to either (i) sell a stock at a specified price or (ii) buy a stock at a specified price.
- (i) The right to sell a stock is called a Put Option.
- (ii) The right to buy a stock is called a Call Option.
Typically, stock traders make a profit by buying shares at a lower price and selling them at a higher price. However, options trading allows traders to profit even when stock prices decline, which is one of the key distinctions of options. Because options tend to have high volatility, they carry a higher risk of loss, so traders must be cautious when trading options.
Traders use options to specify a specific price for a stock. This means setting a price at which they can buy or sell the stock before the expiration date. If the buyer exercises the right before the expiration date, the seller is legally obligated to sell (or buy) the stock at the agreed-upon price. If the option expires without being exercised, it becomes worthless.
Buying Calls
If a trader expects a stock’s price to increase, they will buy a Call Option.
By purchasing a call, the trader pays a premium to obtain the right to buy 100 shares of the stock at the strike price before the expiration date.
Buying Puts
If a trader expects a stock’s price to decrease, they will buy a Put Option.
By purchasing a put, the trader pays a premium to obtain the right to sell 100 shares of the stock at the strike price before the expiration date.
Selling Calls
If a trader expects a stock’s price to decline, they may sell a Call Option.
If the buyer decides to exercise their right before expiration, the seller is obligated to sell 100 shares at the strike price. This strategy is also known as a Covered Call when the seller owns the underlying stock.
Selling Puts
If a trader expects a stock’s price to rise, they may sell a Put Option.
If the buyer decides to exercise their right before expiration, the seller is obligated to buy 100 shares at the strike price.
Example: Call Option
A call option grants the right to buy a specific stock at a predetermined price on or before the expiration date.
Call Option Example
Suppose Apple stock is currently $150 per share.
- You write (sell) a call option that gives the buyer the right to purchase Apple stock at $150 per share in one month.
- The buyer (X) pays you a premium for this right.
Scenario 1: Apple Stock Price Increases
- One month later, Apple’s stock price rises to $160.
- Since X has the right to buy at $150, they will exercise the call option to buy at a lower price.
- You are obligated to sell the stock at $150, even though the market price is $160.
- X profits, and you potentially lose if you do not already own the stock.
Scenario 2: Apple Stock Price Decreases
- One month later, Apple’s stock price falls to $140.
- Since X would lose money by buying at $150, they do not exercise the option.
- The call option expires worthless.
- X loses only the premium paid, while you keep the premium as profit.
Example: Put Option
A put option grants the right to sell a specific stock at a predetermined price on or before the expiration date.
Put Option Example
Suppose Apple stock is currently $150 per share.
- You write (sell) a put option that gives the buyer the right to sell Apple stock at $150 per share in one month.
- The buyer (X) pays you a premium for this right.
Scenario 1: Apple Stock Price Increases
- One month later, Apple’s stock price rises to $160.
- Since X would be selling at $150 while the market price is $160, they do not exercise the option.
- The put option expires worthless.
- X loses only the premium paid, while you keep the premium as profit.
Scenario 2: Apple Stock Price Decreases
- One month later, Apple’s stock price falls to $140.
- Since X has the right to sell at $150, they will exercise the put option and sell to you at a higher price.
- You are obligated to buy the stock at $150, even though the market price is only $140.
- X profits, while you incur a loss.
