Stock Options: Understanding Puts and Calls
- In This Quick Guide:
- What Is an Option?
- What Are Puts and Calls?
- Calls
- Puts
To understand “puts” and “calls,” you first need to understand what stock options are. In this guide we’ll explain stock options, then show you how puts and calls are used.
What Is an Option?
In general, an option gives a person the right to purchase or sell something in the future. For instance, when a Hollywood producer options a best-selling novel, he or she pays the author an amount of money—for instance, $25,000—for the right to buy the book as the basis of a movie, at a certain price (let’s say $500,000) within a certain period of time (usually one to two years).
An option has value because it locks in the price of an item for a certain period of time, as well as the right to buy it. The price of the option is usually a small fraction of the price of the item. Also, an option is not an obligation to buy or sell something. The decision to buy or sell remains with the holder of the option (which is why it’s called an option rather than a purchase or sale agreement).
What are Puts and Calls?
Puts and calls are both stock options:
- A put gives its holder the right to sell a specific number of shares of a specific stock at a specific price—known as the exercise price (or “strike price”)—by a certain date.
- A call gives its holder the right to buy 100 shares of a stock at a specific strike price by a certain date.
Puts and calls are sold by the person or institution who owns the underlying stock. Companies do not sell options on their own stocks, which, in effect, would be “betting” on the price movements of its own stock when their focus should be improving the value of the stock.
Calls
Let’s start with call options. The buyer of a call option hopes that the price of the stock will rise above the strike price before the option expires. The buyer of the option wants to buy the stock at a (strike) price below its market value before the option expires, and then sell the stock at the market price and pocket the difference. For this to be profitable, the difference between the strike price and market price must be greater than the amount paid for the option.
Example: Say you have an option to buy stock in XYZ Inc. at a strike price of $50, and you paid $5 per share for that option. If the price rises to $55 before the option expires, you make no money if you exercise the option. That’s because if you exercised the option, you would buy 100 shares at the strike price of $5,000 and sell them for $5,500—but you paid $500 for the calls, and therefore you would make nothing. (In fact, you would lose money because of transaction costs, which are omitted here to simplify the calculations.) Thus, you would not exercise the option if the price rose to $55 a share or less, nor, of course, would you exercise it if the stock fell (or remained) below the strike price of $50.
However, if the price of the stock were to rise to, say, $60, you would definitely exercise the option. You would buy the 100 shares at the strike price of $50, promptly sell them for $6,000, deduct your costs of $500 for the option and $5,000 for the 100 shares, and pocket a $500 profit.
Yes, this is a simplified example, and, true, options are a sophisticated investment vehicle in which money can be lost as easily as it is gained (perhaps more easily). Moreover, most options are not exercised before the expiration date because the stock price is such that the holder allows them to expire (because the price of the stock vis-a-vis the strike price of the options would not allow the holder to make any money by exercising them). However, the fact that calls enable an investor to profit from a rising stock price without actually buying the stock is the underlying logic and motivation for buying them.
Puts
Again, a put option gives its holder the right to sell a stock at the strike price to the seller of the put (known as the “writer”). (In other words, the writer of the put agrees to buy the stock at the strike price from the holder of the put by the strike date.) The buyer of a put is betting that the price of the stock will fall before the option expires. He makes his profit by buying the stock on the open market at a price below the strike price and then exercising the option, which forces the writer of the put to buy the stock at the strike price from the holder of the put.
Example: Suppose you hold an option to sell 100 shares of ABC Company to Joe Smith (the writer of the put) at a strike price of $50. Suppose, again, that you paid $5 per share for the option. If the price of the stock falls to, say, $40, you would buy 100 shares on the open market and then exercise the put. That put option compels Joe to buy 100 shares from you at the strike price of $50 a share, for a total price of $5,000. You make $500, which is the $5,000 Joe paid you, minus the $4,000 you paid for the stock on the open market and minus the $500 you paid for the option.
As with call options, the difference between the strike price and the stock price must exceed the price of the put (plus transactions costs), or there is no point in exercising it. If the holder does not exercise the put option, then, as with calls, he loses the amount he paid for the option. Finally, as with calls, puts offer the possibility of high returns.
Meanwhile, the writer of the put is hoping that the stock price rises, remains the same, or falls by less than the price of the put. If any of those things occur, then the put is not exercised and the writer of the put, Joe Smith in our example, does not have to buy the 100 shares. Smith’s profit on the transaction is the $500 paid to him for the put.
Again, both puts and calls enable investors to profit on the movement of a stock’s price—upward in the case of calls, downward in the case of puts—without having to buy the stock itself. This limits the potential loss to the amount paid for the options. Good luck in the market!
From The Complete Idiot’s Guide to MBA Basics, Third Edition, by Tom Gorman
