Options - Understanding Calls and Puts

Call and put options are examples of stock derivatives - their value is derived from the value of the underlying stock. For example, a call option goes up in price when the price of the underlying stock rises. And you don't have to own the stock to profit from the price rise of the stock. A put option goes up in price when the price of the underlying stock goes down. As with a call option, you don't have to own the stock. But if you do, the put acts as a hedge - as the stock price goes down, the value of the put goes up so you are hedged against the downside.

You make money on options if your bet on the direction of price movement of the underlying stock is correct. If not, you'll probably loose most or all the money you paid for the option. Options are very sensitive to changes in the price of the underlying stocks. Like gambling you can make or lose money very quickly.

Because option prices change quite rapidly, owning them requires that you spend a significant amount of time monitoring price changes in the stock and the option. And if you're wrong about the price movement, be prepared to lose all or a significant portion of the money you paid for the options.

Buying a Call

A call is a contract that gives the owner the right, but not the obligation, to buy 100 shares of a stock at a fixed price, called the strike price, on or before the options expiration date. For example, assume you buy a June $120 call option (the option expires on the third Friday of June). The strike price is $120. If the stock price reaches $120, the value of the contract increases $100 for each $1 increase of the stock. So if the price of the stock moves from $120 to $135, the value of the option increases by $1,500.

If the price of the stock goes above the strike price and you want to buy the 100 shares, you can exercise the option and buy the 100 shares for $120 per share no matter the current value of the stock.

If the value of the stock goes down, the price of the option goes down, and you could hold it or sell it at a loss.

You may sell the option for a profit or loss anytime before the contract expires.

The price that you pay for a call option depends on many factors two of which include: the duration of the contract (the longer the duration, the more you pay) and how far the current price of the stock is from the strike price of the contract.

Alternative Actions for the Call Buyer
What the call buyer may do. . . . .	Result
Sell option at a profit if the stock price rises.	Take profit.
Sell option at a loss if the stock price does not rise.	Lose part of purchase price.
Let option expire and take loss if the stock price does not rise.	Lose all of purchase price.
Exercise call option if the stock price rises above the strike price. Buy 100 shares at strike price, which is less than market price (buy stock for less than it's worth).	Own 100 shares of stock.

Buying a Put

If you own a stock, you may buy a put as a form of insurance. If the stock falls in price, the put rises in price and helps offset the paper decline in the underlying stock. If you don't own the stock but think it will go down in price, you buy the put to profit from the decline in price of the stock. If the stock price declines, the value of the put rises and you would sell the put for a profit. If the stock increases in price you may sell the put for a loss.

A put option is a contract that gives you the right, but not the obligation, to sell a stock at a preset price. For example, if you buy a put with a strike price of $50, you could sell 100 shares of the stock to the put seller when the stock price fell below $50. So if the stock fell to $30, you could sell it for $50 and the seller is obligated to buy the stock at $50 even though the current price is $30 - not a good deal for the put seller.

The price that you pay for a put option depends the duration of the contract (the longer the duration, the more you pay) and how far the current price of the stock is from the strike price of the contract.

Put buying is different from selling short. With a put option your only liability is the price you paid for the put. With a short sale, you have an unlimited downside liability if the stock goes up. Also, the proceeds from selling short are in a margin account so you have to pay interest and meet margin requirements. Buying puts is a more conservative way of betting on a stock declining in price.

Alternative Actions for the Put Buyer
What the put buyer may do. . . . .	Result
Sell option at a profit if the stock price declines.	Take profit.
Sell option at a loss if the stock price does not decline.	Lose part of purchase price.
Let option expire and take loss if the stock price does not decline.	Lose all of purchase price.
Exercise option if the stock price declines. Sell 100 shares at strike price, which is more than market price (sell stock for more than it's worth). Put buyer must own 100 shares to sell. Can already own them or buy them at market price, which is less than strike price.	Collect proceeds from stock sale.

Selling a Call

For every buyer of a call there must be a seller, who assumes that the stock price will remain flat or go down. The seller collects the purchase price of the option but has the obligation to sell 100 shares of the stock if the buyer decides to exercise the option. If the seller gets called - he must sell the stock. If the stock continues to appreciate in price after the stock is sold, the seller looses the future price gain.

In most cases you must own 100 shares of the stock for each contract you sell - this is called a covered call. Therefore, if your stock gets called away, you have the 100 shares in your account.

You can sell covered calls to generate a stream of income. If the stock price does not rise enough during the period of the contract, you won't get called and won't have to sell the stock so you keep the money you received when you sold the call.

If your broker lets you, you may sell "uncovered "or "naked" calls in a margin account. This practice lets you sell calls when you don't own the stock. If you get called, you must buy the stock at its current market value to cover the call even when the market price is higher than the strike price of the option. Like any margin account transaction, you must execute the transaction immediately.

Alternative Actions for the Call Seller
What the call seller may do. . . . .	Result
Sell 100 shares at the strike price to the call buyer if the call buyer exercises the call option. If the call seller already has shares in his account, they are sold to the buyer at the strike price. If the call seller does not have shares, he must buy the shares on the open market at a price greater than the strike price.	Sell stock for less than it's worth.
Do nothing if the call buyer does not exercise the call option.	Keep all proceeds from sale of call option.

Selling a Put

The seller of a put collects the purchase price of the option from the buyer of the put. The seller has the obligation to buy 100 shares at the strike price regardless of the market value of the underlying stock. So if the put buyer decides to exercise the put contract, the seller of the put has to buy the 100 shares at the strike price no matter the current market value of the stock.

For example, the buyer of a put with a strike price of $50 decides to exercise the option, which means he sells 100 shares of the stock at the strike price to the put seller. The put seller must pay $50 per share even though the market value is, for example, $40. When you sell a put, you want the price of the stock to go up so you don't get the stock put to you - buy the stock for more than it's worth.

Selling a put places the money you receive in a margin account so you pay interest on the proceeds until the put contract is closed. If you don't have the financial resources to cover the obligation of buying the stock from the buyer of the put, you sold "naked puts".

This is a very dangerous position as shown by the following excerpt taken from "Blowing Up", an article in the The New Yorker magazine (April 22 & 29, 2002). It tells about a trader who sold naked puts and experienced financial ruin. "A year after Nassim Taleb came to visit him, Victor Niederhoffer blew up. He sold a very large number of options on the S&P Index, taking millions of dollars from other traders in exchange for promising to buy a basket of stocks from them at a preset price if the market ever fell below a certain point. It was an unhedged bet, or what was called on Wall Street a "naked put"...... On October 27, 1997, the market plummeted seven per cent, and Niederhoffer had to produce huge amounts of cash to back up all the options he'd sold at pre-crash strike prices. He ran through a hundred and thirty million dollars - his cash reserves, his savings, his other stocks-and when his broker came and asked for still more he didn't have it. In a day, one of the most successful hedge funds in America was wiped out. Niederhoffer was forced to shut down his firm. He had to mortgage his house. He had to borrow money from his children. He had to call Sotheby's and sell his prized silver collection...." Niederhoffer experienced the black swan, a very low probability event that causes great losses.

Alternative Actions for the Put Seller
What the put seller must do. . . . .	Result
Buy 100 shares from the put buyer if the put buyer exercises the put option. Note: If the put seller already has money in his account to buy the stock, the put option is covered. If the seller r does not have money to buy the stock, the put option is naked. The put seller must come up with money to buy the stock.	Buys stock for more than it's worth.
Do nothing if the put buyer does not exercise put option.	Keep all proceeds from sale of put option.

Conclusions and Recommendations

Use calls and puts judiciously. If you're right, you can make quick money. If you're wrong, you can lose part or all of your investment very quickly. Do not sell "naked" options. You may be inviting a financial disaster.

Knowledgeable, experienced investors may want to sell covered calls and puts to collect other peoples money.

Because the price of options can change very quickly and dramatically, you must continually watch their price movement. If you not prepared to do so, don't buy or sell options.

Updated February 9, 2008.