Simply trading stocks can get boring. Buy low, sell high -- blah, blah, blah. If you're looking for something a bit more complicated or merely need a rush, trading call or put options might be the way to go. You'll need to learn how options function, however. Once you do, basic options strategies tend to present limited loss potential -- usually just the amount you paid to buy the option contract -- and unlimited upside reward.
Definition
Listed as part of a each option contract is a strike price and expiration date. When you purchase an option contract, you have the right -- or "option" -- to buy or sell the underlying interest, usually a stock. You can exercise your option once the underlying security hits the strike price, however, you must do this before the option expires. At expiration, the option ceases to exist and no longer has value. One option contract gives you the right to buy or sell 100 shares of the underlying stock.
Calls
You can buy or sell a call option. When you buy a call option, you have the right, but not the obligation, to purchase the underlying security at the strike price, on or before the option's expiration date. You can simply choose to trade the option, which is likely to increase in value as the underlying stock nears or exceeds the strike price. You can also allow your option contract to expire, however, as noted, this renders it worthless and you lose your initial investment.
If you choose to sell a call option, you are known as a writer. You are selling call options to a buyer who has the right to exercise his option to purchase the underlying stock. If the buyer of your call exercises his right to purchase the stock, you must buy the stock at the market price and sell it to the holder of the call option at the strike price.
Puts
Puts are simply the opposite of calls. If you buy a put option, you are betting that the underlying security will drop in value. When you buy a put, you have the right, but not an obligation, to sell the stock at the strike price. This can be extremely profitable. Consider buying a $40 put on a stock that drops to $25. One option contract gives you the right to sell 100 shares of the stock at $40 on or before the option expiration date, giving you a profit of $1,500.
When you sell a put option, you want a stock's price to rise so that the buyer of the put you sold will not exercise his right to sell the stock. In this case, you would pocket the option premium. If the stock dropped and the buyer of your put exercised her option, you would have to purchase the stock at the strike price and sell it at the lower market value, setting yourself up for a loss.
Examples
If you purchase a call option contract at $4.00 for XYZ company with a strike price of $20 and an expiration date of January 10, you have the option to buy the stock if it hits $20 on or before January 10. If the stock rose to $25, you could buy 100 shares at $20 for $2,000 and turn around and sell the shares at the market price of $25 for a profit of $500. You could also just sell the option contract before it expires.
If you purchase a put option with the same strike price and expiration date, you have the option to sell the stock if it hits $20 on or before January 10. If stock hit $15, you could sell 100 shares of the stock at $20 for a $500 profit. Clearly, buying calls is a bullish strategy, while buying puts is a bearish strategy.
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Writer Bio
As a writer since 2002, Rocco Pendola has published numerous academic and popular articles in addition to working as a freelance grant writer and researcher. His work has appeared on SFGate and Planetizen and in the journals "Environment & Behavior" and "Health and Place." Pendola has a Bachelor of Arts in urban studies from San Francisco State University.