With the explosion of option use in recent years, you may be asking yourself, "What are options, and why would anyone consider using them?"

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

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 each may be entered into for different strategic reasons.

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. If the call buyer decides to buy – also 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 Procter & Gamble (NYSE:PG) with a strike price at $60, expiring in October. Today, that call would cost around $70 per 100 shares, or $0.70 per share. That call buyer has the right to exercise that option anytime between now and Oct. 16, to pay buy P&P shares for $60. The writer of the call would have the obligation to deliver those shares and be happy receiving $60 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 with the stomach to buy Wells Fargo (NYSE:WFC) for less than $12 amidst the February and March's despair now sit on some sweet gains. And while they may believe that the company will continue to do well, perhaps they still harbor some gnawing concern that this recovery has been "too much, too fast." If they're concerned about the possibility of Wells Fargo sliding during a market pullback, they could buy a put option at the $22.50 strike to "protect" their gains. Buyers of the put have the right, until expiry, to sell their shares for $22.50. Sellers of the put have the obligation to purchase the shares for $22.50 (which could hurt, in the event that shares of Wells Fargo were to decline severely).

Why use options?
Call buyers profit when the price of the underlying shares rises, since the call price will rise as the shares do. Call writers are making the opposite bet, hoping for stock price declines (or, at least, for the stock to rise less than the amount they receive for selling the call in the first place).

Put buyers profit when the underlying stock price falls, since the put price increases as the underlying stock price decreases. 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 by an amount less than what they've been paid to sell the put.

You certainly don't need options to make money in the stock market, but there are several reasons why you may want to consider using them. Calls and puts -- alone, combined with each other, or even in addition to positions in the underlying stock -- can provide various levels of leverage or protection to a portfolio.

  • Options can act as insurance to protect gains: Research In Motion (NASDAQ:RIMM) has more than doubled in the past five months, returning to a valuation some might consider "pricey." Buying a put option can lock in those gains ... minus the cost of the put.
  • Options can help investors get cheaper entry prices for their stocks. Suppose someone wanted to buy shares of VMware (NYSE:VMW), but was concerned about the price tag. Instead of setting a limit order, one could sell puts on the stock. If the stock reaches the strike price and the put is executed, the put writer's net purchase price would be lower by the amount they collected. If it doesn't, the put writer pockets the amount money for which the put was sold.
  • Options can be used to generate steady income from an underlying portfolio of blue-chip stocks like Johnson & Johnson (NYSE:JNJ) or Kraft (NYSE:KFT).
  • Or they can be employed in an attempt to double or triple your money almost overnight.  This strategy's not for the faint of heart (or perhaps strong of brain). Still, buying calls on beaten down small-caps like Apollo Investment (NASDAQ:AINV) in March 2009 would have paid off handsomely.

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. The chance for a quick double or triple has the accompanying risk of losing the money you paid for the option.

The Foolish bottom line
Remember: Calls are the right to buy a stock, and puts are the right to sell a stock. For every buyer of an option, there's a corresponding seller. Different option users may be employing different strategies. If you're interested in using options, it's important to know how to use them appropriately in your own portfolio. To help you do that, check out our free video series -- just enter your e-mail in the box below for access.

This article was originally published on April 24, 2007 under the headline “Options: The Basics.”  It has been updated.

Jim Gillies owns shares of Apollo Investment, but no other companies mentioned. Johnson & Johnson and Procter & Gamble are Income Investor recommendations. VMware is a Rule Breakers selection. The Fool owns shares of Procter & Gamble and has a disclosure policy.