Options: The Basics

By Markets Fool.com


Image source: Chicago Board Options Exchange.

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Options are among the most misunderstood investments, as many investors aren't familiar with even the most basic elements of how options work. Many people mistakenly assume that options are risky, noting how many options expire worthless. Others think options are only for corporate executives. Yet ordinary investors can use options strategies in many productive ways, so it's worth learning some options basics to help you understand what options are and how they work.

What options are

Put simply, an option gives you the right either to buy or to sell shares of stock for a certain price on or before a fixed date. There are two types of options: call options and put options. Call options give the holder of the option the right to buy stock. Put options, on the other hand, let the option holder sell stock.

For every option trade, there's a person who buys the option and another person who sells or writes the option. The buyer pays the seller an amount known as the premium, which the seller is entitled to keep regardless of what happens in the future.

The option buyer then has a decision to make. At some point before the option expires, the buyer has the right to exercise the option and make the specified transaction take place immediately. Exercising isn't mandatory, though; the buyer can also choose simply to let the option expire and do nothing.

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With a call option, if the option buyer decides to exercise the option, then the buyer pays the amount specified in the option contract, and the seller delivers the shares of stock to the buyer. As a result, the total cost of buying that stock is the sum of what the buyer paid for the option and the specified price of the stock.

Similarly, with a put option, if the option buyer exercises the option, then the buyer delivers the stock specified in the option contract to the option seller. In exchange, the option seller pays the specified amount for the stock. Here, the net proceeds that the option buyer receives for the stock is the difference between the specified price of the stock and the price the buyer paid for the option.

The option buyer always has the right simply to sell the option to someone else, rather than exercising it. Similarly, the option seller can buy back either the same option from the original buyer or an identical one from someone else who wants to sell. Doing so effectively closes the position.


Image source: Chicago Board Options Exchange.

Most options trade on public exchanges. For instance, the Chicago Board Options Exchange, operated by CBOE Holdings , is a major exchange that trades many different kinds of options. Other exchanges also offer options of different sorts, covering not only stocks but also ETFs, various financial indexes, and financial and commodity futures contracts.

What strategies are there for options?

Options strategies can get quite complicated. But at their most basic level, options boil down to a few things. First, when you buy a call, you want the underlying stock price to go up. The seller of the call, on the other hand, doesn't want the stock price to rise. Conversely, when you buy a put, you want the underlying stock price to go down, but the seller of the put wants it not to go down.

Options strategies can fulfill many different purposes:

  • Simply buying options can help you make a bet on the direction of a stock without committing as much money per share as you would through buying the stock or selling it short.
  • Buying put options when you already own the underlying stock can act as a hedge against falling prices. Similarly, writing call options on a stock you already own -- also known as a covered call strategy -- can earn you extra income from the premium you get from selling the option, albeit at the price of potentially having to deliver your stock if the option buyer exercises the option.
  • Because options prices are so much lower than stock prices, you can effectively control many more shares of stock through options for any given amount of money. That leverage can magnify both your profits and your losses.
  • Some options strategies that employ a combination of options can help you profit from a wide variety of situations. For instance, some strategies are designed to make money if the stock stays within a tight range, while others maximize their value through a big share-price move in either direction.

It's true that many options investors use options as ways to boost their leverage and make immense profits when they make a smart pick. But there's far more to options than that, and if you explore everything that options have to offer, they can really enhance your investing arsenal.

The article Options: The Basics originally appeared on Fool.com.

Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends CBOE Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.