Puts, calls, strike prices, expiration dates... the lexicon can be intimidating to a newcomer. But, trading options isn't the wizardry it may appear to be from the outside. In fact, with just a few minutes worth of reading a trader interested in capitalizing on the power and benefit of options can be ready to do so.
An option, in simplest terms, is a type of contract that gives you the right (though not an obligation) to purchase 100 shares of a particular stock at a pre-determined price by a certain date. The advantage of such a contract is that it simply gives an option owner the ability to buy shares in a company at a price lower than its stock's price may be in the future. Or, conversely, an option can also give a trader the right to sell 100 shares of a particular stock at a price above that stock's future price. An optional err may not want to exercise their right to buy or sell though shares in the future, as doing so may not make financial sense. For many traders though, paying a nominal price for the "option" to do so is a worthy speculation... particularly given this significant upside potential of an option trade.
There are only two basic types of options - calls and puts.
A call option grants its owner the right to buy, or 'call,' 100 shares of a particular stock before that option contract expires. Clearly in this case the buyer of the call believes that the underlying stock is going to move higher before the contract expires. As the underlying stock gains in price, so too does the value of the option itself. The trader can choose to exercise his/her right to buy though shares at a better-than-market price, though more often than not that trader will simply choose to sell the option for a profit.
That pre-determined a selling price is called a "strike price," and there are several strike prices available for call options on most stocks at any given time.
The "expiration date" is just what it sounds like... the last date a trader has to make a decision about what to do with that call option; they can make that decision on any trading day all the way through the expiration date. Like strike prices, there are always a myriad of expiration date options for any given stock at any point in time.
As is always the case, an example best illustrates these concepts.
Let's use Coca-Cola (KO) as our example. We believe in early January that Coke shares are positioned to rise from their current price of $41.00 to a price of $50.00 within the next six months (July). To "trade" the idea, one could purchase a Coca-Cola $39.00 call with an expiration date of August 18th, at a price of $3.66.... pr $366 (100 shares x $3.66). This contract would mean its owner could buy 100 shares of KO at a price of $39.00 anytime before August 18th. Or, assuming Coca-Cola shares move to that targeted price of $50.00 by mid-August, the trader could simply sell the option for what would be a price somewhere around $12.00... or $1200 for the whole contract (100 shares x $12.00). In percentage terms, that would be the more fruitful trade. The option trade would also not tie up all the capital necessary to outright purchase 100 shares of KO.
Of course, with greater potential reward comes greater potential risk. Should Coca-Cola shares fall below $39.00 and stay there through August 18th, that contract would lose the bulk of its value rather quickly, and have no value whatsoever at the time of expiration. There also be no purpose in using the contract to purchase 100 shares of Coke, because though shares could be purchased on the open market for less than $39.00 each.
Different expiration dates and different strike prices will alter the price of an option. Generally speaking, the riskier an option is, the cheaper to be comes. Conversely, the safer and option trade is, the greater its costs. The further out the expiration date is, the more an option costs. And, the lower the strike price on a call option, the higher its price. The traders simply needs to determine the appropriate risk/reward balance for a particular trade.
A put option mechanically works the same way, but with one key difference - put options gain in value when the underlying stock loses value. They can be used as a speculative trade, where a trader chooses to buy them and then sell them later at a higher price, or as is the case with a call option, a put can be exercised -- its owner can sell 100 shares of that stock at a pre-determined price before the option expires. The only consideration is that the trader must actually own 100 shares of the stock in question to exercise the option.
Most traders choose to simply sell the put option for a profit rather than use it to exit a position. But, there are instance here exercising makes sense.
Again, the best way to understand a put option is with an example.
Let's assume that in June we have good reason to think Microsoft (MSFT) shares are positioned to move lower within the next three months, from their current price of $66.00 to a price of $60.00. The September $70.00 puts could be purchased for $4.90, or $490 per contract (100 shares x $4.90). If MSFT shares do end up falling to $60.00 before September's expiration date, the put option would increase approximately $6.00 in value. That would allow the trader to make an exit at around $10.90 per contract... proceeds of $1090. That's a $600 profit, or a 122% gain, on the trade.
Of course, more than one contract can be traded at any given time, if a trader wanted a bigger position. And, different expirations and different strike prices will change the entry prices and potential price changes of any given option. They all work in the same basic manner though, allowing for a lot of leverage of capital, with minimal risk. Go here, to part-two of this discussion, to learn about how option pricing works.