After your introduction , you may be asking, so, what are these option things, and why would anyone consider using them? Options represent the right but not the obligation to take some sort of action by a predetermined date. That right is the buying or selling of shares of the underlying stock. There are two types of options, calls and puts. And there are two sides to every option transaction -- the party buying the option, and the party selling also called writing the option.
The buyer of the option is said to have a long position, while the seller of the option the writer is said to have a short position. Note that tradable options essentially amount to contracts between two parties. The companies whose securities underlie the option contracts are themselves not involved in the transactions, and cash flows between the various parties in the market. What's a call option? A call is the option to buy the underlying stock at a predetermined price the strike price by a predetermined date the expiry.
The buyer of a call has the right to buy shares at the strike price until expiry. The seller of the call also known as the call "writer" is the one with the obligation. We'll discuss the merits and motivations of each side of the trade momentarily. What's a put option? If a call is the right to buy, then perhaps unsurprisingly, a put is the option to sell the underlying stock at a predetermined strike price until a fixed expiry date.
A call buyer seeks to make a profit when the price of the underlying shares rises. The call price will rise as the shares do. The call writer is making the opposite bet, hoping for the stock price to decline or, at the very least, rise less than the amount received for selling the call in the first place.
The put buyer profits when the underlying stock price falls. A put increases in value as the underlying stock decreases in value. Conversely, put writers are hoping for the option to expire with the stock price above the strike price, or at least for the stock to decline an amount less than what they have been paid to sell the put.
We'll note here that relatively few options actually expire and see shares change hands. Options are, after all, tradable securities. As circumstances change, investors can lock in their profits or losses by buying or selling an opposite option contract to their original action. Calls and puts, alone, or combined with each other, or even with positions in the underlying stock, can provide various levels of leverage or protection to a portfolio.
But no matter how options are used, it's wise to always remember Robert A. Insurance costs money -- money that comes out of your potential profits. Steady income comes at the cost of limiting the prospective upside of your investment. Seeking a quick double or treble has the accompanying risk of wiping out your investment in its entirety. The Foolish bottom line Options aren't terribly difficult to understand.
Calls are the right to buy, and puts are the right to sell. For every buyer of an option, there's a corresponding seller. Different option users may be employing different strategies, or perhaps they're flat-out gambling. But you probably don't really care -- all you're interested in is how to use them appropriately in your own portfolio. How options are quoted, and how the mechanics behind the scenes work.
Check out more in this series on options here. Jim Gillies has no position in any stocks mentioned. The Motley Fool recommends Intel.
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