Lessons › Advanced track › Options basics: calls and puts
World 10 · Advanced track · lesson 3 · level 4
Options basics: calls and puts
An option is a ticket that gives the right, but not the duty, to buy or sell at a set price on or before a set date.
In one line
For a small fee you can lock in a price without ever having to use it. What's the catch?
Explained simply
An option is like paying a small deposit to hold a bike at today's price for a month. If the bike's price jumps, you use your right and buy it at the old price, and if it drops, you walk away and lose only the deposit. The deposit is the premium, and the locked-in price is the strike.
The lesson
A call option gives its buyer the right to buy the underlying asset at the strike price, and a put option gives the right to sell it, either at any time until expiry (American style) or only at expiry (European style). The buyer pays a premium to the seller, who takes on the obligation. An option is in the money when using it at today's price would be worth something before counting the premium paid, at the money when the strike is at or near the current price, and out of the money otherwise. In the US one stock option contract generally covers 100 shares, so a premium of 2.20 dollars costs 220 dollars per contract.
A worked example
Illustrative example: a stock trades at 100. You buy one call with a strike of 105 that expires in a month, for a premium of 2.00 per share. One contract covers 100 shares, so it costs 2.00 x 100 = 200 dollars, and that is your maximum loss. At expiry, if the stock is at 103, the call is out of the money and expires worthless, so you lose the 200. If the stock is at 110, the call is worth 110 - 105 = 5 per share, or 5 x 100 = 500 dollars, a profit of 500 - 200 = 300 dollars.
The same idea at four levels
- Beginner. An option is a ticket that gives you a right, not a duty, to buy or sell at a set price.
- Foundation. A call is the right to buy and a put is the right to sell; the set price is the strike and the price of the ticket is the premium.
- Intermediate. A call is in the money when price is above the strike, and a put is in the money when price is below the strike.
- Advanced. The buyer's worst case is losing the whole premium, which happens if the option expires out of the money, while the seller collects the premium but takes on the obligation and the bigger risk.
- Expert. Check the exercise style and contract size before trading, because many index options, including most US index options and NSE's Nifty 50 options, are European style and can only be exercised at expiry.
Mistakes to avoid
- Thinking an option buyer is forced to buy the shares at expiry, when it is a right, not a duty.
- Forgetting that the whole premium is lost if the option expires out of the money.
- Forgetting the contract size, so a 2.00 premium really costs 200 per contract.
Check yourself
What does a call option give its buyer?
The right to buy at the strike price. A call is a right to buy, not a duty.
What is the premium?
The price paid for the option. It is the price of the ticket.
A put option gives the right to do what?
Sell. A put is the right to sell at the strike.
The stock is at 100 and a call's strike is 90. Is the call in, at or out of the money?
In the money. You could buy at 90 something worth 100.
The premium is 2.00 per share and a contract covers 100 shares. What does one contract cost?
200 dollars. 2.00 times 100 shares is 200.
Goal of this lesson: Understand calls, puts, strike prices, expiry and premium.