An option contract is an agreement wherein the owner has
the right to buy or sell a security or an asset at a
particular price on a fixed date in the future. It is
called an option because the owner of the contract is
not committed to carry out the obligation of the
contract if he or she feels that it is disadvantageous.
There are two types of options contracts: call options
and put options.
Call Options
In simple terms, call options give the owner the right
to buy the underlying asset in the contract. Again, it
is not an obligation.
For example, John and Tom agreed on a call options
contract wherein John will buy from Tom, 100 shares
(equivalent to one option) of Company A at $20 (strike
price) what will expire on the third Friday of April.
The current price of the share is $20.
At the expiry date (also called maturity date), the
share price of Company A remains at $25. John can then
exercise his right to buy the share for $20 and thus,
yielding $5. Meanwhile, if the share price goes down to
$22, John can still earn $2 by simply exercising his
rights as stated in the contract. In whichever way, any
amount higher than the strike price at the end of the
contract will become the profit of the owner. But before
it can happen, the owner who decides to pursue his right
has to have his money ready to pay for the amount.
However, if the share price goes down below $20, say
$18, on the maturity date, it will be too expensive for
John so he can just ignore the contract since he is not
obliged to carry it out. He will only lose the amount he
paid for the contract called the Option Premium. Tom, on
the other hand will keep the asset and the premium,
which in a sense, is his profit.
Put Options
In put options, the buyer has the right to sell an asset
to the writer (the seller). Just like the call asset, it
is bounded by a contract which states that the
underlying asset will be sold at a particular price and
a particular date. But the similarity ends there. In put
options, the writer has to buy the underlying asset at
the strike price if the buyer exercises this option.
Let us continue with John and Tom. John bought call
options from Tom. But he could also buy put options from
Tom. If John buys put options, it means that he buys the
right to sell Company A’s shares at $20 on April 1. If
the price of shares goes down below $20 on the expiry
date, John can exercise his right and can still sell it
at $20, thus making a profit.
Buying put option allows investors to earn when price of
shares drops at the end of the contract.
Profit potentials are unlimited for the buyers of put
options, especially if the market begins to sell off. On
the other hand, risks are limited if the market goes
against them.
Important note:
In reality, trading of options or transactions does not
happen between two persons. Buying or selling can happen
without knowing the identity of the other party.
Options are only sold in 100 share lots. So if the share
price is $20, you will have to pay $2,000 for each
option contract plus the Option Premium.