Options are contracts between a buyer, known as the option holder, and a seller, who is the option writer.
Such a contact gives the holder the right, but not the obligation, to buy or sell an underlying security at a set price by an expiration date. This set price is known as the strike price.
Trading options is a great opportunity for investors to earn a substantial return. However, option trading is risky and could lead to a loss, especially for option buyers who do not understand the risks and rewards. Let’s look at a few basic examples of call and put options that will show exactly how to make a profit and avoid a loss from investing in options.
Call Option Examples:
- Long Call Strategy (holding a call option): Company “ABC” has a price per share of $20. An investor could buy call option for ABC with a strike price of $25 that expires in one month. The option buyer would expect the stock price to rise above $25 per share in the next month. That option buyer gains the right to buy 100 shares of ABC at a price of $25 until the expiration date. One option is equal to 100 shares of the underlying stock. Let’s assume the premium for the call option costs $2 per share. In that case, the option buyer pays $200 to the option writer. The premium paid is the maximum amount the option holder can lose when buying a call option. Say the share price of ABC rises to $30 in that month. Now, the option holder can exercise the call option and buy 100 shares of stock at $25 each, rather than $30 per share, for a total of $2,500. The call option holder then can sell the shares at the market value price of $30 per share to generate a profit of $3,000 – $2,500 – $200 = $300. However, if the share price never rises above the strike price, then the call option expires and leaves the option holder with a loss of $200 paid for the premium.
- Short Call Strategy (writing a call option): Company “ABC” has a price per share of $20. The option writer expects the market value of ABC to decrease or stay the same. Thus, he decides to write one call option for a premium of $2 per share, or a total of $200. That $200 is paid to the option writer. Assume the option has a strike price of $22 and expires in three weeks. If in those three weeks, ABC never rises to $22, the call option expires worthless. In that case, the option writer keeps the $200.
Put Option Examples:
- Long Put Strategy (holding a put option): Company “ABC” has a price per share of $102. An investor, known as an option holder, can buy one put option of ABC with a strike price of $100 that expires in one month. He expects that the market value of the stock is going to decrease. The holder of the put option now has the right to sell 100 shares of ABC at a price of $100 until the expiration date. Assume the premium for the put option costs $3 per share. Then the option buyer would pay $300 for one ABC put option. Suppose the share price of ABC drops to $95. The option holder then exercises the put option and buys 100 shares of stock at $95 for a total of $9,500 and has the right to sell it for $100. The option writer is obligated to buy the shares at the price of $100, even though the market price is $95. This generates a profit for the holder of $10,000 – $9,500 – $300 = $200. However, if the share price never falls below the strike price, then the put option expires and the option holder loses the $300 he paid for the premium.
- Short Put Strategy (writing a put option): Imagine purchasing 100 shares of Company “ABC” at a market price of $50 per share. The option writer expects the share price of ABC not to fall below $45 in the next two weeks. The option writer collects a premium of $2 per share, or $200 total, by writing one put option on ABC with a strike price of $45 that expires in two weeks. ABC closes above $45 in the next two weeks. The put option expires and becomes worthless. So, the option writer keeps the $200 premium and the 100 shares he owns. If ABC closed below $45, then the option could have been exercised and the option writer would have been obligated to sell his 100 shares for $45 per share. This would be a loss for the option writer of $4,500 – $5,000 + $200 = -$300.
These basic examples of call and put options can be used by investors to make informed and strategic decisions about options trading.