Buying Stocks 101

For the novice investor, stock options tend to garner one of two emotions: lust or fear.  On one side, you have those who have been warned to never trade options because they are perceived to be too risky and difficult to master.  One the other side, there are those who view them with awe and burn to understand them, fueled heavily by traveling stock gurus on the seminar circuit.  But Options are just another tool in your investment arsenal, and every serious investor should educate themselves on how and when to use them.  To that end, I will unpack the basics of stock options and hopefully provide a launching pad for further exploration or experimentation.

What is an Option?

At its core, a stock option is a contract between a buyer and a seller which gives the buyer the right to buy (call) or sell (put) an asset (usually a stock) on a set date in the future at an agreed price.  An option buyer has the RIGHT to buy, but not the obligation.  An option seller has the OBLIGATION to sell.  So what does the seller get?  In return for granting the option, the seller collects a payment (called a premium) from the buyer.

Types of Options

There are two types of options: calls and puts.  A call option gives the buyer the right to buy the asset under the terms of the contract.  If the call is excercised, the seller MUST sell to the buyer at the agreed upon price.  A put option gives the buyer the right to sell the asset under the contract terms.  If the put is excercised, the seller of the contract MUST buy the asset from the buyer at the agreed upon price.  But either way, the buyer has the choice of whether to excercise the option to buy or sell, or simply let the option expire.

Basic Stock Option Trades

In American-Style stock options, there are four basic trades which form the bulk of option transactions.  In the U.S., one option contract usually represent 100 shares of the underlying security.

Long Call

When an investor buys a call option on a stock expecting that the stocks price will INCREASE, this is known as a long call.  If the stock price upon the date of expiration of the option contract is above the strike price by more than the premium paid for the contract, then the investor will make a profit.  If the price doesn’t go up that much, he would just let the option expire and only be out the money he paid for the contract.  An investor may buy an option for the security instead of the security itself because he could buy more options than shares, and thus have a higher potential gain.

Long Put

An investor who believes a stock will DECREASE, might buy the right to sell the stock at a fixed price.  If the price at expiration is below the strike price by more than the premium paid for the contract, then the trader will profit.  If not, he only loses the premium.

Short Call

If an investor believes a stock will DECREASE, he might choose to sell (or write) a call.  If the stock price decreases, the investor will profit by the amount of the premium paid by the investor who bought the call.  If it increases over the strike price, he will be obligated to sell to the call buyer if the buyer exercises their right to call.

Short Put

On the other hand, if the investor believes the stock price might INCREASE, he might sell a put.  This means that if a stock goes down below the strike price, he would be obligated to buy the stock from the put buyer if he exercises his option.  But if the stock price is above the strike price when the contract expires, the investor will make a profit in the amount of the premium.

Summary

Understanding stock options isn’t a subject that can be fully covered in a short post like this one.  But, like buying stocks, once you grasp the basics mentioned here, you will have enough knowledge to start to investigate some of the option strategies which make the risk and reward much more interesting.