Call Options and Put Options: A Quick Explanation

I hear a lot of people talk about stocks, and they ask about options.

Options can be really cool, but many people do not even really know what they are. Some sort of know.

Let's try taking care of that here.

With anything--not just stocks--options are simply an opportunity to buy or sell something. They usually have added constraints:

• buy OR sell something (not both)
• specify the buy/sell price
• offer is available only for a certain pre-determined time period (1 day, 1 month, 3 years, etc.)

What is the downside to buying options?

They cost money.

What is the upside to buying options?

They give you control of the investment (stock, property, car, etc.) without putting up only a fraction of the amount to POSITION yourself to buy or sell that investment.

You are not required to buy or sell; you just bought the RIGHT to buy or the right to sell that investment, and you defined the terms.

This means that you LEVERAGE your money to buy the same amount of investment. (If you are a risk taker, this also means that you can leverage the same amount of money to buy more of an investment. Be extremely careful here!)

Is there another downside to buying options?

Yes. Sometimes, you buy an option, and it expires and becomes worthless. That means that you spent money for something you did not use--a little like buying insurance on a car that you never crashed.

In stocks, there are two (2) types of options: Call Options and Put Options.

Call Options

Call options give you the RIGHT to BUY stock

1. at a certain price
2. for a certain period of time (before it expires).

It costs a certain amount of money to do this, and you are NOT obligated to buy this stock at the price.

Example:

Today's Price: $35/share
Option Price: $2/share
Strike Price (right to buy stock at this price): $40/share
Expiration: 1 month

Situation A: Price 1 Month Later: $45/share

Since you bought the option, you can buy a share of this stock for $40/share today, even though today's price is $40/share.

Your Cost: $2/share + $40/share = $42/share
Your Profit: $45/share - $42/share = $3/share
Return: 150% ($3 Profit / $2 Cost = 1.50 or 150% Return)

So you made a big profit by only investing a small amount.

Situation B: Price 1 Month Later: $35/share

Since you bought the option, you can buy a share of this stock for $40/share today, even though today's price is $35/share.

Are you going to spend $40/share if you can get the same thing for $35/share today? Probably not. The option expired worthless.

Your Cost: $2/share
Your Profit: NONE. You lost $2/share.
Return: 0%; but you didn't lose that much (compared to

It's important to realize that you don't always "win" when you invest in options. Since you can lose your entire investment, it CAN be a risky investment.

Generally, you want to buy call options in an UPWARD moving market.

Put Options

Put options give you the RIGHT to SELL stock

1. at a certain price
2. for a certain period of time (before it expires).

It costs a certain amount of money to do this, and you are NOT obligated to sell this stock at the price.

Example:

Today's Price: $35/share
Option Price: $2/share
Strike Price (right to buy stock at this price): $30/share
Expiration: 1 month

Situation A: Price 1 Month Later: $25/share

Since you bought the option, you can sell a share of this stock for $30/share today, even though today's price is $25/share.

Your Cost: $2/share
Your Profit: $30/share (Your Price) - $25/share (Today's Price) - $2/share (Option Price) = $3/share
Return: 150% ($3 Profit / $2 Cost = 1.50 or 150% Return)

So you made a big profit by only investing a small amount, and you took advantage of the marketing moving DOWNWARD.

Situation B: Price 1 Month Later: $40/share

Since you bought the option, you can sell a share of this stock for $30/share today, even though today's price is $40/share.

Are you going to sell your stock for $30/share if you are able to sell it for $40/share today? Probably not. This option expired worthless.

Your Cost: $2/share
Your Profit: NONE. You lost $2/share.
Return: 0%; but you didn't lose that much (compared to the original $35/share for the actual stock)

Again, it's important to realize that you do not always "win" when you invest in options. Since you can lose your entire investment, it CAN be a risky investment.

Generally, you want to buy put options in a DOWNWARD moving market.

Options can be a great way to invest without risking a lot of your investment. Your returns on your investment tend to be very high--WHEN they work. When they do not work, you can lose everything.