Calls and Puts in Plain English: Your First Guide to Options

An option is a contract that gives you the right, but not the obligation, to buy or sell something at a set price before a set date. You pay a fee for that right. If things go your way, the right becomes valuable. If they do not, the fee is gone.

The four pieces of every option

• Underlying. The thing the option is based on, usually a stock or an index. One standard stock option controls 100 shares.
• Strike price. The price at which you may buy or sell.
• Expiration. The date the contract ends. After that, it is worthless.
• Premium. The price you pay for the contract, quoted per share. A premium of $2.00 on one contract costs $200 ($2.00 x 100 shares).

Calls: the right to buy

A call gains value when the stock goes up. Suppose a stock trades at $100. You buy one call with a $105 strike that expires in 30 days, and you pay a $2.00 premium, so $200 in total.

• Your maximum loss is the $200 you paid. If the stock finishes at or below $105, the call expires worthless.
• Your break-even at expiration is $107, the strike plus the premium.
• If the stock reaches $115, the call is worth $10 per share, or $1,000. After the $200 cost, that is an $800 profit, before commissions and fees.

Puts: the right to sell

A put gains value when the stock goes down. With the stock at $100, you buy a put with a $95 strike for a $2.00 premium ($200). If the stock falls to $85, the put is worth $10 per share, or $1,000, a $800 profit after cost. If the stock stays above $95, you lose the $200. Puts are also used as insurance: an investor who owns the stock can buy a put to limit how much a drop can hurt.

Buyers and sellers are not the same

Everything above describes the buyer of an option, whose loss is limited to the premium. The seller, also called the writer, collects the premium but takes on an obligation. A seller of an uncovered ("naked") call can face losses far larger than the premium, because a stock can rise without a ceiling. This is why brokers require approval levels for options trading and why beginners should start with defined-risk positions.

Why you can be right and still lose

An option's price has two parts. Intrinsic value is how far in the money it already is. Time value is the extra you pay for the chance that it gets there before expiration. Time value shrinks every day, and it shrinks faster as expiration nears. This is called time decay, or theta. It means that if you buy an option and the stock moves in your direction too slowly, you can still lose money.

A few other "Greeks" you will meet in Track 02:

• Delta. How much the option price moves when the stock moves $1.
• Theta. How much value the option loses per day from time passing.
• Vega. How sensitive the price is to changes in expected volatility.

Risk comes first

• Risk only a small, fixed percentage of your account on any one trade.
• Prefer options that trade often and have tight bid and ask prices. Thinly traded options cost more to get in and out of.
• Know your exit before you enter: the price at which you cut the loss, and the one at which you take profit.
• Practice in a simulated account until your process is consistent.

Options reward people who understand them and punish people who treat them like lottery tickets. Learn the mechanics first, and the strategies that follow, such as spreads that cap your risk, become far less mysterious.

This article is for education only and is not financial, investment, tax or legal advice. Trading involves substantial risk of loss.