Calls and Puts

If you want to trade options, Call and Put are the two important phrases that you need to get familiarized with. When someone talks about trading options, it has to be either a call or a put. Two more phrases that are good to know are long and short. In general buying something to own is long and selling without owning is short.

Any stock that is trading on stock markets with options will have Calls and Puts listed for different strike prices and that stock is referred as underlying. Note that not all stocks will have options.

Legendary investor Warren Buffet’s Berkshire Hathaway (BRK-A) trades on New York Stock Exchange (NYSE) does not have options. An interesting fact about this company is a single share of BRK-A costs about $123,500.00 as of September 9, 2010 if you don’t know already.

Call
A Call is an options contract that gives the buyer the right to exercise the option and buy the underlying stock at the strike price on or at any time up to the expiration date.

An options trader can be long a Call, in which case they have bought a Call contract, and have the right of exercise described above. Or a trader can be short a Call, in which case they have sold a Call contract, and may be required to sell the underlying commodity if they are chosen by the exchange (or options clearing system) to complete their contract obligations.

For a better understanding, let’s look at Caterpillar Inc.’s shares closed at $70.64 as of September 9, 2010. When a buyer is long 5 contracts of Sept. 70 CAT calls means s/he bought a right to control 500 shares of CAT until the close of third Friday of September (17th) by paying 1.57x5x100 = $285.00 not including the commissions.

An option contract usually represents 100 shares of the underlying. If this buyer has to make money CAT share price should be more than $71.57 (70.00 strike price + 1.57 option price) by Sept. 17th of 2010 though they closed at $70.64 Sept. 9th of 2010. The difference between the closing price of the stock and the option price + strike price is called the premium. In this example it is (70.00+1.57) - 70.64 = 0.93 cents. Buyer is paying this premium for the time value left before the expiration of the option.

All options have a limited life. They are defined by a specific expiration date. The picture below is a snapshot of CAT’s options table for September expiration that can be found on yahoo finance site.

source: yahoo finance

Three different scenarios are expected by the expiration date.

Stock price stays at or below $70.00: call option expires worth less and buyer looses all the money paid for buying those 5 contracts ($285.00). Seller gets to keep that money.

Stock price surges past $70.00 and much more: Buyer can exercise the option and buy 500 shares of CAT for $70.00 a piece either to keep as an investment or sell in the open market the current price and pocket the profit assuming selling over $71.57. The seller has an obligation to sell 500 shares at $70.00 though the shares are trading higher than $71.57.

Third possibility is the call buyer sells those contracts before the expiration either for a profit if the share price goes up and the call option price moves above $1.57 or at a loss if the share price drops.

Most traders do not exercise their options; instead they will close it sometime before it expires. This rarely happens and there is not much benefit to doing this, so don’t get caught up in the formal definition of buying a call option.

You can also sell (or write) call options. This process exposes the option writer to virtually unlimited risk. You are essentially taking the other side of the trade that a buyer of a call option makes. Most traders buy call options because they believe the price of a stock is going to move higher and they want to profit from that move. You can also exit the option before it expires – during market hours, of course.

Put
A Put is an options contract that gives the buyer the right to sell the underlying stock at the strike price on or at any time up to the expiration date. Again don't get caught up in the formal definition.

An options trader can be long a Put, in which case they have bought a Put contract, and have the right of exercise described above. Or a trader can be short a Put, in which case they have sold a Put contract, and may be required to buy the underlying if they are chosen by the exchange (or options clearing system) to complete their contract obligations.

Mostly, a put option yields an opposite result to that of a call option. In other words a call option buyer makes a profit when the stock price moves up within the expiration date and a put buyer makes when the stock loses its price value.

A put option buyer is betting on the stock’s price moving lower before the expiration.

Apart from the fact that options are a best instruments of leverage as each contract controls 100 shares of underlying traders use options in many different ways and combinations to benefit from the stock price movements.

So, now we are at a point how to choose a proper option to buy? We will see that in the next post. Do come back for more lessons on options.