Options: calls and puts

A ticket, not the thing

A new game console is coming out for $300, and everyone wants one. The store lets you pay $5 to hold one at $300 for a month.

• If the price jumps to $400, you can still buy it for $300. Nice deal.
• If the price drops to $250, you just walk away. You lose only your $5.

That $5 deal is like an option. An option is a contract that gives you the right, but not the duty, to buy or sell a stock at a set price before a set date.

The words

• Call: the right to buy at a set price. Call buyers hope the price goes up.
• Put: the right to sell at a set price. Put buyers hope the price goes down, or want protection.
• Strike price: the set price.
• Expiration: the last day the option is alive.
• Premium: what you pay for the option.
• For US stocks, one options contract usually covers 100 shares. Prices are shown per share, so you multiply by 100.

A call, step by step

Sunny Slice is at $30. You think its next earnings will be great. You buy one call:

• Strike: $32
• Expires in 2 months
• Premium: $0.80 per share, so $0.80 × 100 = $80

What happens on the last day?

• The stock is at $38. You can buy 100 shares at $32 that are worth $38. The call is worth $6 × 100 = $600. Take away the $80 you paid: you made $520.
• The stock is at $32 or lower. Nobody wants to buy at $32 when the market price is the same or lower. The call ends worth nothing. You lose $80, and that's the most you can lose.
• Breakeven: $32 + $0.80 = $32.80. Above that, you profit.

Notice something. The stock had to rise more than 9% (from $30 to $32.80) just for you to break even, and it had to do it within 2 months. Being right about the direction isn't enough. You have to be right about how far and how fast.

A put, step by step

Same stock at $30. This time you buy one put:

• Strike: $28
• Premium: $0.60 per share, so $60

• The stock falls to $22. You can sell 100 shares at $28 that are only worth $22. The put is worth $6 × 100 = $600. Minus $60: you made $540.
• The stock stays above $28. The put ends worth nothing. You lose $60.
• Breakeven: $28 minus $0.60 = $27.40.

Puts are also used like insurance. Someone who owns 100 shares of Sunny Slice can buy a put to protect against a big drop, the same way people pay for insurance on a house.

Every buyer has a seller

For every option someone buys, someone else sold it. The seller collects the premium. If Sunny Slice shoots up to $38, the seller of that call has to sell shares at $32, and loses money. A buyer can lose at most the premium. A seller can lose much more. That's one reason brokers make people get approved before trading options, and in the US you have to be an adult to do it.

You don't have to use it

Actually buying or selling the shares with your option is called exercising it. Most traders never do. They just sell the option itself before expiration, because its price changes every moment the market is open. Most US stock options can be exercised on any day before they expire.

The honest truth

• With options, a small amount like $80 can swing a lot. That works in both directions.
• Many options end up worth nothing, and many beginners who buy options lose money.
• Time works against the buyer. Every day that passes, the option loses a little value. The next lesson shows why.

Remember

• A call is the right to buy at the strike. A put is the right to sell at the strike.
• One contract usually covers 100 shares, so the cost is the premium × 100.
• An option buyer can lose at most the premium they paid.
• To win, you must be right about direction, size and timing.