Options: The Basics

After your introduction, you may be asking, so, what are these option things, and why would anyone consider using them?

Options represent the right (but not the obligation) to take some sort of action by a predetermined date. That right is the buying or selling of shares of the underlying stock.  

There are two types of options, calls and puts. And there are two sides to every option transaction -- the party buying the option, and the party selling (also called writing) the option. Each side comes with its own risk/reward profile and may be entered into for different strategic reasons. The buyer of the option is said to have a long position, while the seller of the option (the writer) is said to have a short position.

Option Trades

Call Buyer (Long Position) Call Seller (Short Position)

Put Buyer (Long Position)

Put Seller (Short Position)

Note that tradable options essentially amount to contracts between two parties. The companies whose securities underlie the option contracts are themselves not involved in the transactions, and cash flows between the various parties in the market. In any option trade, the counterparty may be another investor, or perhaps a market maker (a type of middle man offering to both buy and sell a particular security in the hopes of making a profit on the differing bid/ask prices).

What's a call option?
A call is the option to buy the underlying stock at a predetermined price (the strike price) by a predetermined date (the expiry). The buyer of a call has the right to buy shares at the strike price until expiry. The seller of the call (also known as the call "writer") is the one with the obligation. If the call buyer decides to buy -- an act known as exercising the option -- the call writer is obliged to sell his/her shares to the call buyer at the strike price.

So, say an investor bought a call option on Intel (Nasdaq: INTC  ) with a strike price at $20, expiring in two months. That call buyer has the right to exercise that option, paying $20 per share, and receiving the shares. The writer of the call would have the obligation to deliver those shares and be happy receiving $20 for them. We'll discuss the merits and motivations of each side of the trade momentarily.

What's a put option?
If a call is the right to buy, then perhaps unsurprisingly, a put is the option to sell the underlying stock at a predetermined strike price until a fixed expiry date. The put buyer has the right to sell shares at the strike price, and if he/she decides to sell, the put writer is obliged to buy at that price.

Investors who bought shares of Hewlett-Packard (NYSE: HPQ  ) at the ouster of former CEO Carly Fiorina are sitting on some sweet gains over the past two years. And while they may believe that the company will continue to do well, perhaps, in the face of a potential economic slowdown, they're concerned about the company sliding with the rest of the market, and so buy a put option at the $40 strike to "protect" their gains. Buyers of the put have the right, until expiry, to sell their shares for $40. Sellers of the put have the obligation to purchase the shares for $40 (which could hurt, in the event that HP were to decline in price from here).

Why use options?
A call buyer seeks to make a profit when the price of the underlying shares rises. The call price will rise as the shares do. The call writer is making the opposite bet, hoping for the stock price to decline or, at the very least, rise less than the amount received for selling the call in the first place.

The put buyer profits when the underlying stock price falls. A put increases in value as the underlying stock decreases in value. Conversely, put writers are hoping for the option to expire with the stock price above the strike price, or at least for the stock to decline an amount less than what they have been paid to sell the put.

We'll note here that relatively few options actually expire and see shares change hands. Options are, after all, tradable securities. As circumstances change, investors can lock in their profits (or losses) by buying (or selling) an opposite option contract to their original action.

Calls and puts, alone, or combined with each other, or even with positions in the underlying stock, can provide various levels of leverage or protection to a portfolio.

  • Option users can profit in bull, bear, or flat markets.
  • Options can act as insurance to protect gains in a stock that looks shaky.
  • They can be used to generate steady income from an underlying portfolio of blue-chip stocks.
  • Or they can be employed in an attempt to double or triple your money almost overnight.

But no matter how options are used, it's wise to always remember Robert A. Heinlein's acronym: TANSTAAFL (There Ain't No Such Thing As A Free Lunch). Insurance costs money -- money that comes out of your potential profits. Steady income comes at the cost of limiting the prospective upside of your investment. Seeking a quick double or treble has the accompanying risk of wiping out your investment in its entirety.

The Foolish bottom line
Options aren't terribly difficult to understand. Calls are the right to buy, and puts are the right to sell. For every buyer of an option, there's a corresponding seller. Different option users may be employing different strategies, or perhaps they're flat-out gambling. But you probably don't really care -- all you're interested in is how to use them appropriately in your own portfolio.

Next up: How options are quoted, and how the mechanics behind the scenes work.

Check out more in this series on options here.

If you are interested in receiving more information from The Motley Fool about investing in options, please click here.

Fool contributor Jim Gillies owns no shares of any company mentioned. Intel is an Inside Value pick. The Fool has a disclosure policy.


Read/Post Comments (19) | Recommend This Article (229)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 20, 2008, at 7:19 PM, MSGTB wrote:

    I thought that buying a put on a stock was like shorting the stock. I am referring to this table.

    Call Buyer (Long Position)

    Call Seller (Short Position)

    Put Buyer (Long Position)

    Put Seller (Short Position)

    Thanks

    Dave

  • Report this Comment On August 21, 2008, at 1:05 AM, JFrazer1 wrote:

    @ Dave,

    If you buy a put and the stock decreases in value, then the put decreases in value, so it is a short position. If you buy full coverage car insurance, and you decrease the value of the car by crashing it, the insurance suddenly increases a lot in value, as it pays off your car. So in a sense, car insurance is going short position on your car's condition, life insurance is going short on your life, medical insurance is short on your health, house insurance is short on your house's structural integrity, and so on.

    If you by a put, you are gaining the right to sell the stock at a guaranteed price. You are limiting your potential losses because you will not have to sell below that price. Because of the leverage of options, you can use a small amount of money to buy a put but have your losses completely covered if the stock drops.

    You can use buy a put outright to go short on a stock or use it in conjunction with stock you own as insurance.

  • Report this Comment On August 21, 2008, at 1:06 AM, JFrazer1 wrote:

    @ Dave

    Nevermind, I see your point, that table is screwed up.

  • Report this Comment On August 21, 2008, at 1:11 AM, JFrazer1 wrote:

    I think they are just making the point that if you are writing options contracts and selling them to open, you are hoping you are selling at the best possible price and that the price of the option will go down after that point. In that sense any time you sell something you are 'short' on it. Buying a put would be long on the put, short on the underlying asset.

  • Report this Comment On September 21, 2008, at 11:45 AM, notsure2 wrote:

    On August 21, 2008, at 1:05 AM, JFrazer1 wrote: Report this Comment

    @ Dave,

    If you buy a put and the stock decreases in value, then the put decreases in value, so it is a short position.

    ---------------------------

    When I buy puts and stock goes down my puts go up in value.

  • Report this Comment On October 29, 2008, at 7:52 PM, totsubo wrote:

    On the second page there is this statement:

    'the put writer is obliged to sell at that price.'

    That is incorrect, put writers are obliged to buy, not sell. Please update the article.

  • Report this Comment On April 21, 2010, at 8:00 PM, Bloefeld wrote:

    When you take a short position and the stock goes higher you have liability of the difference between your short position and the price of the stock. You can have unlimited liability.

    In the case of an option your only at risk the cost of the option itself. So options are a cheaper and less expensive way to protect gains.

    Or so I think,

    Cheers,

    Bloefeld

  • Report this Comment On August 11, 2010, at 8:31 PM, platelet100 wrote:

    Can one exercise a call option at anytime. Does one simply notify the broker he wants to exercise the option?

  • Report this Comment On October 20, 2010, at 2:51 PM, dylan33 wrote:

    I think i may have a problem - because I kinda understand what jessicamoore123, above, is saying?

  • Report this Comment On April 20, 2011, at 3:20 AM, VinayKallatFool wrote:

    @platelet100

    Can one exercise a call option at anytime. Does one simply notify the broker he wants to exercise the option?

    Depends on the exercise style of the option.If it's American Style then you can exercise any time on or before Expiration. European-style option contracts may only be exercised at the option's expiration date.

  • Report this Comment On April 20, 2011, at 3:38 AM, VinayKallatFool wrote:

    I can see a lot of debate goin on with the table

    Option Trades

    Call Buyer (Long Position) Call Seller (Short Position)

    Put Buyer (Long Position)

    Put Seller (Short Position

    I agree to what JFrazer1 has to say about short selling and its 100% correct.

    But what the table meant was on a different note.We generally in fianace domain term Seller of a options having a short position and buyer of a option as having a long position.This is because the writter has an obligation to sell the option(Not with refrence to the underlyin secuirty. It is still buy in case of underlying instrument for put option.but in other words sellin of put option u can say.hope have not confused u all..) where as the will of a buyer persist.He may or may not buy the option contract.So it brings us to the defination of long and short positions.

    Long position:You have the right to collect the dividends or interest the security pays, the right to sell it or give it away when you wish, and the right to keep any profits if you do sell.

    Similarly, you have a long position in an option when you hold the option, and you have the right to exercise it before expiration or sell it.

    Short Position:The sale of a security or derivative, or the state of having sold one or the other. It is important to note that a short position is not closed, and is applied only to sales where further action may be required. For example, one who has borrowed securities and has then sold them is said to be have a short position with respect to that security, because he/she must eventually return an equivalent amount of the borrowed securities. Likewise, one who has sold (or written) an option is in a short position, because the option may be exercised at a later date.

  • Report this Comment On April 20, 2011, at 4:37 AM, VinayKallatFool wrote:

    In short summarizing the whole story into:

    Buying(Buyer) of Call Option means buying of underlying insrtument which is a long position.

    Selling(Writter) of a Call Option means selling of underlying insrtument which is a short position.

    I think this was okie with all..

    Now buying (Buyer) of PUTOption means selling of underlying insrtument which is a long position with respect to the option bought as he has the right to buy the contract which in turn means selling the underlying instrument.

    Now Selling(Writter) of PUTOption means buying of underlying insrtument which is a short position with respect to the option sold as he has the obligation but not right (as it depends on the buyer) to sell the contract which in turn means buying the underlying instrument.The writer receives a premium from the buyer. If the buyer exercises his option, the writer will buy the stock at the strike price. If the buyer does not exercise his option, the writer's profit is the premium.So the writter is at short position with respect to the options instrument and not the underying instrument.

  • Report this Comment On June 09, 2013, at 6:44 AM, optionsmm wrote:

    In the first section "Options Trades" the description of the Puts is backwards.

    Option Trades:

    --Call Buyer (Long Position) ;Call Seller (Short Position)

    --Put Buyer (Long Position);Put Seller (Short Position)

    Should Read:

    --Put Buyer (Short Position);Put Seller (Long Position)

    The text in the article is right but the table needs to be fixed

  • Report this Comment On June 20, 2013, at 3:09 PM, athometz wrote:

    @optionsmm

    The table in the article is correct:

    Call & Put Buyer (Long Position/Straddle)

    Call & Put Seller (Short Position/Straddle)

  • Report this Comment On November 14, 2013, at 5:08 PM, Hukleberry wrote:

    Had a call on a stock for 80.00, January 2015. The stock currently is around 99.00 and it got assigned or called. Always thought you had until the strike date or just before to decide what to do with the call. Should have known better.

  • Report this Comment On April 24, 2014, at 10:02 AM, MoneyMakerGuy wrote:

    @ Huckleberry

    You should have sold your option for a gain and kept stock.

  • Report this Comment On June 10, 2014, at 8:00 PM, sep7501 wrote:
  • Report this Comment On June 10, 2014, at 8:01 PM, sep7501 wrote:
  • Report this Comment On October 17, 2014, at 4:23 AM, Dave6831 wrote:

    Thanks Mr. Gillies for confusing the hell out of me. I thought The Motley Fool was aimed at simplifying the investment game. Not a single lamens-terms example can be found anywhere in this article. Just gave me a headache.

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