Options 101 - How Do Options Work?

By Author: Dan George
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Do you ever wonder how the Options work and does it all sound Greek to you when other people are talking about Calls and Puts? First of all, Options are very risky investment and are not suitable for everyone. Options could lose significant value in a very short period of time. Now for everything, you have to learn and begin somewhere. But it is good to understand that Options are high risk - high return type of investment.

When you buy Options, it gives you right to buy/sell the underlying stocks. When you sell options, you have obligation to buy/sell the underlying stocks. There are two types of options, Calls and Puts. Call Options give you right to buy underlying stocks when you buy it. For seller, it creates an obligation to sell the underlying stocks if the buyer wants to exercise his right. When you buy Put Options, it gives you right to sell the underlying stocks and similarly the seller has obligation to buy the underlying stocks if the buyer wants to exercise his right.

Now above definitions are confusing enough for someone trying to understand the basics. So let's dive into the detail. Why would someone ...
... want to buy Call Options or Put Options? Options are the most innovative investment instrument ever invented. If you look at the stock prices today, there are majority of good stocks which a normal individual investor can't reasonably afford. The Options allow the investor chance to invest in these stocks at lower prices and many times at fraction of what the stock price is. So if you think a particular stock is currently trading at an attractive price and it would go higher in future, you can explore the possibility of buying Call Options for that stock. Similarly, if you think a particular stock is trading at higher price and it would go lower in future, buying the Put Options for that stock should be explored. The cost of the Options is called Premium. So the next question arises, why would someone want to sell the Call Options or Put Options?

Short answer, to earn the premium. If you hold some stocks and you think the stock prices for the defined timeframe would remain same, you can explore the possibility of selling the Call Options for little higher price than the current price and collect the premium. This would be called Covered Call since you already own the stocks and would be able to sell it if the buyer later wants to exercise his right to buy the stocks. If you didn't own the stock while selling the Call Options, it would be called Naked Call, this would be the riskiest of Options. Now if you want to buy some stocks at lower price than it is currently trading but don't think it would go down that much in defined timeframe. you can explore the possibility of selling the Put Options at the lower Price and collect the premium. If the stock eventually goes down to that price within that timeframe, you would simply buy the stocks. These are the simplest definitions and explanation.

Let's take some examples to make this clear and understand some more terms associated with Options. Let's consider Microsoft (MSFT) stock, we'll cover some hypothetical examples. You should do proper research and analysis before deciding a stock price would go higher or lower. Let's consider that Microsoft is trading around $27 range and you are bullish and think the price would go significantly higher in next 4 months. You could look at the Calls prices and find $30 Call for about $0.87 per share. One contract option include 100 shares so it would cost you $87. Here the $30 would be called Strike Price and $0.87 is Premium. The premium for any Options gets determined from four main factors; Current Stock Price, Strike Price, Days to Expiration and Implied Volatility. The Options which expire further out would be more expensive because of the time value associated. Also, the stocks with higher implied volatility would cost more. Now for the example we are talking, before the expiry date of Call Options, if and when the Microsoft stock trades above $30.00, the Option would be called 'In the Money'. If you are bearish about Microsoft stock and think that it would go significantly lower in next 4 months, you could consider buying the Put Options of MSFT and find $24 Put for about $0.85 per share. If by expiry date of Put Options, the Microsoft stock trades below $24, the Option would be 'In the Money'.

I would recommend setting exit strategy on Options trades as the value changes very rapidly and you could either lose a lot of money or could miss out on the profits.

Disclosure: I have no positions in any stocks mentioned, and do not intend to initiate any position within the next 72 hours.

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