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The Basics of Stock Options

There are two types of stock options: puts and calls. All option positions, no matter how simple or complicated, are made up of puts and/or calls. (Although some strategies may also use short or long stock in addition to the option position.)

Options trade in "contracts". One contract normally covers 100 shares of stock. Therefore, if you buy one call option contract, you are actually buying the right to buy 100 shares of the underlying stock. If you want to control 1000 shares of stock, you would buy ten call contracts, and so on.

Option prices are quoted per share, but you cannot trade per share, you must trade in contracts that cover 100 shares. Therefore, if you buy one call option contract quoted at $1.50, you will actually be spending $1.50 x 100 = $150.00 (plus commissions). This one option contract gives you the right to buy 100 shares of stock at the strike price, explained later.

Options have an expiration date. They cease to exist after the expiration date. This means that if you buy options expecting a stock to move one way or another, but the stock does not move by the expiration date, your option will become worthless. Expiration dates for stock options are standardized - they expire at the option market close on the third Friday of every month. When you buy or sell options, you can choose the expiration date you wish to trade. The expiration date can be this month, next month, or sometimes over two years away.

There are two ways you can hold a position in each type of option: you can own the option (called being "long") or you can sell the option as an opening transaction (called being "short").

A call option gives the owner of the call (someone who is "long") the right to buy stock at an agreed-upon price known as the strike price. The strike price and expiration date are both part of the option contract. The call option trades for a certain price known as the premium, which the call owner must pay in advance. For instance, if you buy one call option on a certain stock and pay $1.74 for the 30 strike price and next month's expiration, you will pay $1.74 x 100 = $174.00 (plus commissions). What you are buying is the right to buy the stock at $30.00 by the next month's expiration date. If the stock happens to go over $31.74 by that date, your option position will be profitable. You can use the option (called "exercising" the option) to buy the stock at $30.00, spending 100 x 30 = $3,000. Since the current market for the stock is somewhere over $31.74, you can then sell the stock for a gain, or hold on to it like any other stock.

There are always two sides to an option trade. If you buy a call option, it means someone sold it to you. An option trader who sells a call option as an opening transaction is said to be "short" the call.

All purchases and sales of options are anonymous. The details are handled by an organization acting as a middleman. There is no way to know if the other side of your trade is a market maker, another trader, or a huge institution.

An option trader who is short a call receives the premium that the call buyer paid. For instance, if you sell one call option for $1.74, you bring $1.74 x 100 = $174.00 (less commissions) into your account. In return for this premium, you have the obligation to sell the stock at the agreed upon strike price on or before the agreed-upon expiration date, if someone exercises their long call. Even if the stock zooms to $40 (by the expiration date) after you sell a 30 strike call option, when someone exercises their long call you will be required to deliver 100 shares of stock and you will receive 100 x 30 = $3000. If you are not already the owner of 100 shares of stock, you would be required to go into the market, buy stock at the current price of $40, and sell it at the strike price of $30, for a loss on the position even counting the premium received, of ($10 x 100) - $174.00 = ($826.00).

From the above examples you can see one unavoidable feature of option trading, which is that all trades have risk. There is no such thing as free money or a sure thing in the option market. If you are long an option and it doesn't work out, you lose the premium you paid. If you are short an option and it moves against you, you will also lose.

A put option gives the owner of the put (someone who is "long") the right to sell stock at an agreed-upon price known as the strike price. The strike price and expiration date are both part of the option contract. The put option trades for a certain price known as the premium, which the put owner must pay in advance. For instance, if you buy one put option on a certain stock and pay $1.74 for the 30 strike price and next month's expiration, you will pay $1.74 x 100 = $174.00 (plus commissions). What you are buying is the right to sell the stock at $30.00 by the next month's expiration date. If the stock happens to go below $28.26 by that date, your option position will be profitable. You can use the option (called "exercising" the option) to sell the stock at $30.00, bringing in 100 x 30 = $3,000. Since the current market for the stock is somewhere below $28.26, you can then buy the stock for a gain (covering the short sale of stock), or sell your own shares at an above-market price if you owned the stock and were using the long put as protection.

An option trader who is short a put receives the premium that the put buyer paid. For instance, if you sell one put option for $1.74, you bring $1.74 x 100 = $174.00 (less commissions) into your account. In return for this premium, you have the obligation to buy the stock at the agreed-upon strike price on or before the agreed-upon expiration date, if someone exercises their long put. Even if the stock drops to $20 (by the expiration date) after you sell a 30 strike put option, when someone exercises their long put you will be required to buy 100 shares of stock and you will pay 100 x 30 = $3000. Since the stock is currently trading at $20, you would be paying $30 for something worth $20, and even counting the premium received you would have an instant ($10 x 100) - $174.00 = ($826.00) loss on the position.

The motivations of call and put buyers and sellers can be summarized as follows:

  • Long Call is a bullish or accumulative position. You expect the stock to go up. You may want to own a call for the purpose of exercising the call and buying the stock at the strike price, when the price in the market is higher than the strike price. Or you may want to own the call simply as a trader - you expect it to be worth more sometime before expiration than it is now, and you intend to sell the option when you have a profit.
  • Short Call is a bearish or neutral position, or a way to sell stock at a target price. As a trader, you expect the stock to either go down, or not go up. If the stock goes down after you sell a call, the call will be worth less, and you can buy it back at a profit. Or you may just hold onto it until expiration. If the stock is not over the strike price at expiration, the call option will expire worthless, and you will keep the entire premium without further obligation. A short call can also be used as a way to sell stock at a target price. For instance, if you bought stock at $30, you may think that $35 is a fair price for selling your stock, so you could sell a 35 strike call. If the stock is not over $35 at expiration, you keep both the premium received and the stock. If the stock is over $35 at expiration, you will keep the premium, and sell your stock for $35 a share. This particular strategy is called the "Covered Call" or "buy-write". See the Covered Call Strategies Disadvantages page for more about covered calls.
  • Long Put is a bearish or protective position. You either expect the stock to go down, or you want to protect stock you currently own in the event the stock does go down. You may trade the put. If the stock goes down after you buy a put, the put will be worth more, and you can sell it for a gain. You may exercise the put if you own the stock and the stock drops, since your long put gives you the right to sell your stock at a higher price than the current market.
  • Short Put is a bullish, neutral, or accumulative position. You either expect the stock to go up, or not go down, or you are interested in buying the stock at a lower price than the current market. You can trade the short put. If you sell a put, and the stock goes up, the put will be worth less than what you sold it for, and you can buy it back for a gain. You can also hold the short put until expiration. If the stock price stays over the strike price of the put, the put will expire worthless and you will keep the entire premium received, without further obligation. You can also sell a put with the intention of buying stock at less than the current market value. For instance, with the stock at $30, you could sell a 25 strike put. You will bring in premium from the sale, and if the stock is below $25 at the expiration date, you will be obligated to pay $25 x 100 = $2500 for 100 shares of stock, which is $500 plus premium received better than you could have bought the stock for when it was at $30. However, your "bargain" may not look like such a bargain at the time you are required to purchase the stock. The current stock price could be anywhere below $25.

Option traders who are "long" puts or calls have rights, but they have no obligation to do anything.

Option traders who are "short" puts or calls have obligations, but they have no rights to anything.

As mentioned at the top of this page, all option positions consist of puts and/or calls, sometimes with stock as well. When puts, calls, and stock are combined in specific ways that match an option trader's view of a stock or the market, the combination is called an option strategy. Most common option strategies have names and are used to try to take advantage of specific circumstances. See the Option Trading Strategies by Outlook pages for more information about strategies.

 

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