by Dan Keen

There are two types of option contracts: “Calls” and “Puts”.  The buyer of a call option has the right, but not the obligation, to buy a specific stock at a set price (called the “strike price”) anytime on or before the contract’s expiration date.  The buyer of a put option has the right, but not the obligation, to sell the underlying stock at a set price anytime before the expiration date.

Combinations of options (calls and puts) let you benefit from big moves in the market, even if you don’t know if these moves will be up or down.

Buying a Call Option

The buyer of a call option has the right, but not the obligation, to buy a specific stock at a set price, the strike price, anytime on or before the contract’s expiration date.

One option contract controls a block of 100 shares of a stock.  Contracts have an expiration date, and if the contract is to be exercised, it must be done before it expires.  Expiration dates are always the third Friday of the month (technically, they expire on Saturday, but trading ends on Friday).  Each option has a “strike price”, a pre-determined set price for which the underlying stock can either be bought or sold.

When you buy an option, the price you must pay is called the “premium”.  Similarly, when you sell an option, you receive a premium.  As do stocks on the NASDAQ Exchange, there is a “bid” and an “ask” price.  When you buy a stock you pay the ask price; when you sell a stock, you receive the bid price.  It’s the same with options.

Think of buying a call option contract as being similar to a manufacturer’s coupon that you might use at the supermarket.  For example, let’s say you have a coupon to buy one box of ABC brand frozen pizza dinner for $1.00, which is cheaper than the usual price of $2.99.  The coupon has an expiration date one month from now.  The coupon’s current value is $1.99 ($2.99- $1.00).  You can exercise the right to buy that product for $1.00 anytime between now and the expiration date next month.  Once that date passes, the coupon becomes worthless.  If, however, the price of the TV dinner goes up to $3.49 during the month, the coupon locks in your price of $1.  The value of that coupon, which was $1.99 before, is now worth $2.49!

In a similar way, a call option allows the holder to lock in the price of a stock at which it can be purchased on or before the expiration date.  The holder may also choose to sell the call option itself if it goes up in value, which would happen if the price of the underlying stock rises.

Let’s look at an example to clarify.  Suppose it’s May, and XYZ Corporation’s stock price is at $26.50.  Your research points to a strong possibility that the price will go up in the next month or two.  Buying 100 shares of XYZ would cost you $2,650 (plus commission).  That’s a lot of money.  However, a call option for the right to buy XYZ for $30 a share between now and September is going for 75 cents a share.  We could buy one call option contract for $75, plus commission (one contract equals 100 shares of stock).  If the stock doesn’t perform, we only have $75 at risk, rather than $2,650.

We are hoping that the stock will go up in value to $30 and possibly higher.  As the price of XYZ increases, so does the value of the call option.  Suppose the stock does go to $30.  Our option price may go up to $1.50 per share.  That’s about a 10% movement in the stock, yet the value of our option has gone from $75 to $150 – that’s a 100% increase.  We’ve doubled our money, if we sell the option contract!

Buying a Put Option

The opposite of buying a call option is to buy a put option.  When you buy a call, you are betting on the stock going up.  Buying a put option gives you the right, but not the obligation, to sell a stock at a set price anytime on or before an expiration date.  You are hoping the stock will go down in value, in which case the value of the put option increases.

The value of a call option tracks the price movement of the stock: it goes UP when the underlying stock price goes UP, and DOWN when the stock price goes DOWN.  The value of a put option does the opposite: it goes UP when the underlying stock price goes DOWN, and goes DOWN when the stock goes UP.

Puts can be used for protection.  If you are bullish on a stock you own and are looking to benefit from rising prices, but you are nervous about the stock falling and are looking to limit risk, you would buy a put.  It will cost a little money to buy the put, but the put will increase in value if the stock drops in price, and thus help offset the equity loss.

Suppose you own 100 shares of XYZ Corp, which is currently at $68.  Your investment is $6,800.  You are afraid that it may drop in price.  Buy a nine month out put (that is, with an expiration date nine months from now), with a strike price of $60 at a price of $1 per share ($100 total cost).  If the stock falls $10 down to $50, the put will increase by at least $10: now the put is worth $1,000 ($10 x 100).  So, $100 buys you nine months of insurance.  Similar to insurance policies, your “deductible” (the price you must pay if the stock price drops), is the first $800.  Some professionals like to keep a few puts in their portfolio even during bull market periods so that should the market drop unexpectedly, there is something in their portfolio that will increase in value.

Put options are usually 20% to 30% less expensive than call options because of two reasons: when you buy a put, the stock can theoretically only fall to zero.  So there is limited profit on the downside (but, there is a theoretical unlimited profit when you buy a call). And, psychologically, investors don’t like to bet on stocks to drop, therefore, they usually buy calls instead of puts, making a higher demand for calls, which increases call prices.