What is an Option
Options are a financial derivative sold by an option writer to an option buyer. The contract offers the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at an agreed-upon price during a certain period of time or on a specific date. The agreed upon price is called the strike price. American options can be exercised any time before the expiration date of the option, while European options can only be exercised on the expiration date (exercise date). Exercising means utilizing the right to buy or the sell the underlying security.
Breaking Down the Option
Options are versatile securities. Traders buy options to speculate or to hedge current holdings. Trader also attempt to generate income through option writing. Option on stocks typically represent 100 shares. So if an option costs $0.35, buying one option would cost $35 ($0.35 x 100).
In terms of speculation, option buyers and writers have conflicting views regarding the outlook on the performance of an underlying security.
Call options provide the option buyer with the right to buy an underlying security at the strike price, so the buyer wants the stock to go up. Conversely, the option writer needs to give the underlying security to the option buyer, at the strike price, in the event that the stock's market price exceeds the strike price.
An option writer who sells a call option believes that the underlying stock's price will drop or stay the same relative to the option's strike price during the life of the option, as that is how they will reap maximum profit. The writer's maximum profit is the premium received when selling the option.
If the buyer is right, and the stock rises above the strike price, the buyer will be able to acquire the stock for a lower price (strike price) and then sell it for a profit at the current market price. However, if the underlying stock is not above the strike price on the expiration date, the option buyer loses the premium paid for the call option.
Risk to the call buyer is limited to the premium paid for the option, no matter how much the underlying stock moves. The profit at expiration, if applicable, is: Current market price of Underlying – (Strike Price + Premium paid) = Profit. This would be multiplied by the number of contracts and then multiped by 100 (assuming each contract represents 100 shares. This will give the total profit or loss to the trader in dollars.
The risk to the call writer is much greater. Their maximum profit is the premium received, but they face infinite risk because the stock price could continue to rise against them. To offset this risk, many option writers use covered calls.
Put options give the option buyer the right to sell at the strike price, so the put buyer wants the stock to go down. The opposite is true for a put option writer. For example, a put option buyer is bearish on the underlying stock and believes its market price will fall below the specified strike price on or before a specified date. On the other hand, an option writer who writes a put option believes the underlying stock's price will stay the same or increase over the life of the option.
If the underlying stock's price closes above the specified strike price on the expiration date, the put option writer's maximum profit is achieved. They get to keep the entire premium received.
Conversely, a put option holder benefits from a fall in the underlying stock's price below the strike price. If the underlying stock's price falls below the strike price, the put option writer is obligated to purchase shares of the underlying stock at the strike price. The put option buyer's profit, if applicable, is calculated by taking the Strike Price – (Current market price + Premium paid). This is then multiplied by 100 (if each contract is 100 shares) and the number of contracts bought.
The risk to the option writer if the stock price falls is that they have to buy the stock at the strike price. Some traders write put options at strike prices where they want to buy stock anyway. If the price falls to that price, they buy the stock because the option buyer will exercise the option. They get the stock at the price they want, with the added benefit of receiving the option premium.