Options give you the right (without the obligation) to transact a security at a predetermined price within a certain time period. In a call option, the buyer has the right (but is not required) to buy an agreed quantity of a commodity or financial instrument (called the underlying asset) from a seller by a certain date (the expiry) for a certain price (the strike price). A put option is the right to sell the underlying stock at a predetermined strike price by a certain date.
The party that sells the option is called the writer of the option. The option holder pays the option writer a fee -- called the option price or premium. In exchange for this fee, the option writer is obligated to fulfill the terms of the contract should the option holder choose to exercise the option.
Contents: Call Option vs Put Option
The buyer of a call option wants the price of the underlying instrument to rise in the future; the seller either expects that it will not, or is willing to give up some of the upside (profit) from a price rise in return for
- the premium (paid immediately), plus
- retaining the opportunity to make a gain up to the strike price (see below for examples).
The buyer of a put option either believes it's likely the price of the underlying asset will fall by the exercise date, or hopes to protect a long position in the asset. The advantage of buying a put over shorting the asset is that the risk is limited to the premium. The put writer does not believe the price of the underlying security is likely to fall. The writer sells the put to collect the premium.
The following videos illustrate call and put options, the players and risks involved for a stock worth $100:
edit Expiry and Option Chains
There are two types of expirations for options. The European style cannot be exercised until the expiration date, while the American style can be exercised at any time.
The price of both call options and put options are listed in a chain sheet, which shows the price, volume and interest for each strike price and expiration date.
edit Strike Price
For each expiry date, an option chain while list many different options, all with different prices. These differ because they have different strike prices: the price at which the underlying asset can be bought or sold. In a call option, a lower stock price costs more. In a put option, a higher stock price costs more.
With call options, the buyer hopes to profit by buying stocks for less than their rising value. The seller hopes to profit through stock prices declining, or rising less than the fee paid by the buyer for creating a call option. In this scenario, the buyer will not exercise their right to buy, and the seller can keep the paid premium.
With put options, the buyer hopes that the put option will expire with the stock price above the strike price, as the stock does not trade hands and they profit from the premium paid for the put option. Sellers profit if the stock price falls below the strike price.
Options are high-risk, high-reward when compared to buying the underlying security. Options become entirely worthless after they expire. And also if the price does not move in the direction the investor hopes, in which case she gains nothing by exercising the options. When buying stocks, the risk of the entire investment amount getting wiped out is usually quite low. On the other hand, options yield very high returns if the price moves drastically in the direction that the investor hopes. The spreadsheet in the example below will help make this clear.
Consider a real-world example of options trading. Here is a subset of options available for GOOG (so the underlying asset here is Google stock) on a day when the stock price was around $750, taken from Yahoo Finance. The expiry date for all these options is within 2 days. Call options where the strike price is below the current spot price of the stock are in-the-money.
For simplicity, we will only analyze call options. This spreadsheet shows how options trading is high risk, high reward by contrasting buying call options with buying stock. Both require the investor to believe that the stock price will rise. However, call options give very high rewards compared to the amount invested if the price appreciates wildly. The downside is that the investor loses all her money if the stock price does not rise well above the strike price. You can download the spreadsheet here.
edit Trading Options vs. Trading Stocks
Options provide leverage to investors. When the guess is accurate, an investor stands to gain a very high amount of money because option prices tend to be much more volatile. However, the potential for higher rewards comes with greater risk. For example, when buying shares, it's usually unlikely that the investment will be entirely wiped out. However, money spent buying options is entirely wiped out if the stock price moves in the opposite direction than expected by the investor.