Understanding Options - What Are Calls and Puts?

All options are basically contracts on some underlying trading instrument - shares of a stock or share, over a bond contract, maybe over one of the many commodities traded, a mortgage or loan of some sort, etc. (The list is long and covers many different forms of financial instruments.)

But regardless of what the basis for the option contract is, there are common features that all options poses. One of the most basic is the contract feature specifying the rights and obligations that the option buyer or seller has actually contracted for.

What Are Call Options?

A 'call' option confers on the (option) contract holder the right (but not the obligation) to buy an asset at a fixed price on or before a specified expiration date. The owner of a call option always has the choice on whether to exercise his option or let his it expire. (Of course, if he let's it expire worthless, he will lose the initial money he invested in buying the contract.)

Call option buyers are betting the underlying asset - the stock, bond, commodity, etc - will increase in price before the expiration date. And, not only rise, but rise enough for him to make a reasonable profit.

How much of a price rise in the underlying security is enough?

The price of the underlying security needs to rise enough to cover the difference between the market price and the strike price (the strike price is the price which the stock, say, can be purchased). And since the option itself has a cost (called the option premium), the price has to rise enough to cover the additional amount of premium paid.

The cost (the premium) of an option - whether call or put - is determined by several factors, including the price of the underlying asset, the strike price, the time remaining on the option, the volatility of the underlying market, and other things.

The time remaining to option expiry is particularly important. Simple common sense suggests that if you have 90 days to exercise an option, your risk of losing all or part of your premium is lower than if you have 30 days, or indeed only one or two days left. In 90 days the price has the potential to rise the several points needed to generate a profit. 

With less time remaining until expiry, the odds are lower and therefore the risk to the option holder is much higher.

Suppose it's April 1, for example, and Microsoft (MSFT) has a market price of $27. Call options for June 30 are selling for $3 with a strike price of $30. You buy one contract for 100 shares.

So, if you held until expiration you either lose $300 ($3 x 100, the initial price of the contract not including commission), or buy the underlying stock at $30. If the current market price were $35 you've made $200. ($35 - ($30+$3) = $2 per share x 100 shares, ignoring commissions.)

When the market price of a share is above the strike price, the option holder is 'in the money'. If the market price is lower, he's 'out of the money'.

Here's a chart of a strongly rising market where holding call options would be very profitable. Buying additional call option contracts at each higher swing low and compounding your position would have been a very profitable trade...

What Are Put Options?

A 'put' option, on the other hand, gives the option buyer the right (but again, not the obligation) to sell an asset at a certain price by a certain date in the future.

Put options are similar to 'shorting stock', in this sense. Put buyers are betting the stock price will fall before the option expires.

In this case the market price must fall below the strike price in order to profit from exercising the option. (Ignoring the cost of the put, for simplicity.) Under those circumstances, the option holder is 'in the money'.

For example, take the same situation as above but let the option be a put. If the market price falls to, say $25, your profit would be:

First, $3 x 100 = $300 = Cost of put, excluding commissions.

Then, buy 100 shares at $25 per share = $2,500 to repay broker 'loan' (since shorting stock involves borrowing shares you don't own, then repaying later).

Finally, sell 100 shares at Strike price = $30, 100 x $30 = $3,000

Therefore, your profit = ($3000 - $2500) - ($300) = $200.

Here's a chart of a quickly falling market - the setup here would be to buy put options either once the small swing low before the second doji was taken out, or below the prior swing low. These short quick trades can make holding put options very profitable -

Whether investing in calls or puts, wise investors do the needed homework. Options trading is risky and somewhat more complicated than simple stock trading. (Which is already complicated and risky enough.)

Study the history, volatility, and other factors of both the option contract and the underlying asset. Blindly throwing darts at a board is the best strategy for losing money.

A well thought out trading plan along with an understanding of how options work can help you to become a profitable options trader. 

Having said that, the vast majority of options expire worthless, so it pays to have a good grasp of trading trends and an understanding of technical analysis before you enter the options market.

And if you'd like to cut out all the hype and B.S. about learning to trade options and learn EXACTLY how to do it right from an expert, check out The Options University.

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The options trading and technical analysis information shared on this website is for educational purposes only and is not an invitation to buy or sell securities. While everything here is believed to be accurate, it should not be considered solely reliable for use in making actual investment decisions. Trading options is a risky business and you can lose more than your original capital. Always consult a licensed broker or adviser before trading the market.

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