Introduction to Options, Puts, and Calls

By Pinyo, on September 9, 2009

Over the past few years, options trading have become more mainstream with many discount brokers advertising options trading along with other investments such as mutual funds, stocks and bonds. There are even online discount brokers with the word “options” in their names — e.g., OptionsXpress and OptionsHouse. But what exactly are options? An option is a contract that gives you (the buyer) the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Since an option is a contract that deals with an underlying asset, options are called derivatives — which means it derives its value from something else.

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Options

Let’s take a look at an example. Assume you’re in the process of buying a business but need time to evaluate what you’re buying. To make sure you don’t lose out on the opportunity to buy this business, you negotiate with the owner for the right to buy his business for $500,000 any time during the next 3 months. The owner agrees, but asked you to pay $5,000 for this right.

Now we can consider two possible outcomes:

1. After further research, it was discovered that the owner under priced his business. Moreover, there are more interested buyers that are now bidding the price up. In fact, the more appropriate price for this business is $1 million. Because the owner sold you the option, he is obligated to sell you the business at the option contract price of $500,000 as long as you’re still within the 3 months window. In theory, you just made a $500,000 profit from your $5,000 investment.
2. On the flip side, your research could uncover something that makes the business worth less than what you have originally thought. Let’s say, the business is dependent on raw materials with prices that are about to go up drastically. In this case, you choose not to exercise your right to buy his business because you are under no obligation to go through with the sale. In this case, you’d lose $5,000, but that’s better than spending $500,000 on a worthless business.

There are a few important things to take away from this example.

1. When you buy an option, you have the right but not the obligation to buy or sell the underlying asset.
2. If you let your option expires, or if you choose not to exercise your option, you lose 100% of your investment (i.e., what you’ve paid for the option).
3. An option gives you tremendous amount of leverage. For instance, your $5,000 investment resulted in $500,000 profit in the first scenario of our example.
4. An option works as a hedge and limits your risks. For instance, your $5,000 investment prevented $500,000 loss in the second scenario of our example.

Calls

A call is the type of option described above. It gives you the right to buy an asset at a certain price within a specific timeframe. When you buy calls, you’re hoping that the price of the underlying asset will go up before the option expires. A call can also be used to hedge your short position against a short-term price increase.

Puts

A put gives you the right to sell an asset at a certain price within a specific period of time. This is similar to short selling a stock where you hope the price will fall before the option expires. A put can also be used to hedge your long position against a short-term price decline.

That’s the basics of options, puts, and calls. However, you should realize that this is a very complex instrument and should not be taken lightly. In the future, I hope to go deeper into various aspects of options trading as well as provide you with a list of discount brokers that are catered to options trading.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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