Options - Understanding the Basics

An option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date.

Investors buy and sell options just like stocks. There are two basic types of options:

• The call option
• The put option

The Call Option

The call option is the right to buy the underlying security at a certain price on or before a certain date.

You would buy a call option if you anticipated the price of the underlying security was going to rise before the option reached expiration. For example:

Company XYZ is trading at $25 per share, and you believe the stock is headed up. You could buy shares of the stock, or you could buy a call option. Say a call option that gives you the right, but not the obligation, to buy 100 shares of XYZ anytime in the next 90 days for $26 per share could be purchased for $100.

If you are right, and the stock rises to $30 per share before the option expires, you could exercise your option and buy 100 shares at $26 per share and sell them for an immediate profit of $3 per share ($30 - $26 = $4 - $1 for the option = $3 per share profit).

You could also trade the option for a profit without actually buying the shares of stock.

If you had figured wrong and the stock went nowhere or fell from the original $26 per share to $24 per share, you would let the option expire and suffer only a $100 loss (the cost of the option).

The Put Option

The put option is the right to sell the underlying security at a certain price on or before a certain date.

You would buy a put option if you felt the price of a stock was going down before the option reached expiration.

Continuing without XYZ example, if you felt the stock was about to tank from $25 per share, the only way to profit would be to short the stock, which can be a risky move if you’re wrong.

You could purchase a put option at $24 per share for $100 (or $1 per share), which would give you the right to sell 100 shares of XYZ at $24 per share.

If the stock drops to $19 per share, you could, in theory, buy 100 shares on the open market for $19 per share, then exercise you put option giving you the right to sell the stock at $24 per share – making a $5 per share profit, minus the option cost.

As a practical matter, you would trade your put option, which would now be worth something close to $5 per share or $500.

Basic Option Facts

Here are some quick facts about options:

• Options are quoted in per-share prices but are only sold in 100-share lots. For example, a call option might be quoted at $2, but you would pay $200 because options are always sold in 100-share lots.
• The Strike Price (or Exercise Price) is the price the underlying security can be bought or sold for as detailed in the option contract. You identify options by the month they expire, whether they are a put or call option, and the strike price. For example, an “XYZ April 25 Call” would be a call option on XYZ stock with a strike price of 25 that expires in April.
• The expiration date is the month in which the option expires. In general, all options expire on the Saturday after the third Friday of the month unless the options contract states otherwise.
• There are two types of options contracts. American-style options can be exercised at any time before their expiration date, while European-style options can only be exercised on the expiration date.

Conclusion

This quick overview of options gives you an idea of what they are all about, but it is the very tip of the proverbial iceberg. Options are not for the beginning investor but do offer advanced traders another tool for their investment arsenal.

Note: All option quotes in this article are for illustration only. Pricing of options is a complicated process involving many factors.