There are many different types of options, and they’re not all equally risky.  Some options investing strategies are highly risky, whereas others have a much lower level of risk.  If you’re still new to options investing, you might want to first read my post on learning the basics of options trading.

Before you can get into the individual options strategies, though, you need to get very clear on the basic categories of options in general.  There are four of them.  These four types of options really belong to two general categories: calls and puts.  There are two types of calls, and two types of puts.

What Are Call Options?

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The call option gives the owner of the call the right to buy 100 shares of a particular stock.  You get to buy (if you want) 100 shares of a stock at a particular pre-set price at any time up to the pre-set deadline.

Now, make a special note of this: a call option is a product.  It is, precisely, a derivative.  It is derivative upon the underlying stock, since one option represents 100 shares of stock.  Because the call option is a particular financial product, it can be bought and sold (traded) just like any commodity or stock on a stock exchange (or options exchange).

Buying a Call Option

Simple enough then, this means that if you buy a call option, you are purchasing the right to buy 100 shares of stock at a certain price, within a certain time limit.  You don’t have to buy the shares just because you buy the call option, but you’d be allowed to.  You can see the value in this: if you locked in a call option on a stock with a stock price of $30 over the next month, and the stock itself shot up to $40, you could exercise your call and buy the stock $10 cheaper per share.

Selling a Call Option

This is a bit more complicated to understand than the buy transaction, but it’s still straightforward.  Let’s say you are already the owner of 100 shares of Google (Nasdaq: GOOG).  You can “write” (i.e. “sell”) a call for a specific amount, on a certain price of stock, with a certain deadline in mind.  If you sell or write a call, you’d be selling someone the right to buy those shares from you at these prices and by that deadline.

What Are Put Options?

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The put option is the opposite of a call option.  The owner of a put owns the right to sell 100 shares at a certain price by a certain deadline.  You can see how this would be valuable if the stock price tanks, because then you could still sell your shares at the higher price.

For this reason, put options can be understood as a hedge against downward market movements.  Basically, it’s sort of like having a stop-loss in place, but one in which you may or may not own all the underlying stock.  This has to be explained further.  Like call options, these are products and can, in turn, be bought and sold repeatedly.

Buying a Put Option

As Michael Thomsett puts it (sorry for the pun!) in his clear and simple book, Getting Started in Options: “When you buy a put, it is as though the seller were saying to you, “I will allow you to sell me 100 shares of a specific company’s stock, at a specified price per share, at any time between now and a specific date in the future.  For that privilege, I expect you to pay me the current put’s price” (10).

Selling a Put Option

Frankly, this might be the most complicated category of option to understand at first – I know it is for me.  If you’re selling (or “writing”) a put option, you’re selling someone the right to sell 100 shares to you.  That means you might end up having to buy those shares if your buyer decides to exercise his/her right to sell them.  That means you’d better be prepared and capable of buying all those shares at whatever price the put had set them at.  If the stock’s market value tanked, you could lose a lot of money.

Thomsett gives a nice summary of the difference in meaning between calls and puts.  Basically, “a call buyer believes and hopes that the stock’s value will rise, but a put buyer is looking for the price per share to fall” whereas “a call seller hopes that the stock price will remain the same or fall, and a put seller hopes the price of the stock will rise.”

OK, you may ask, then, why sell a put if you can just buy a call (i.e., if you think Royal Bank (TSX: RY) is going to rise, why bother selling a put on it if you can buy a call?)?  I’ll leave you with this question and talk about it in a future post.

I still don’t understand: what’s the whole point of options, anyway?  How do these work?

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