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

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).

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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 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 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.