Option Basics

Hi, this is a three parts series short tutorial on Option Trading Concepts.

OPTION Basics (1) – What is an Option?
OPTION Basics (2) – CALL and PUT (Buyers’ perspective)
OPTION Basics (3) – CALL and PUT (Sellers’ perspective)

OPTION Basics (1) (What is an Option?)

What is an Option?
An option is a contract that provides the buyer/seller with the right to buy or sell the underlying stock (100 shares) at the specified fixed price (strike price) by the specified date (expiration) in the future.

A unit of an Option is called a contract. A contract consists of 100 shares of the underlying stock.

Strike price refers to the price which the buyer/seller agree to transact on irrespective of the actual price of the stock in the future.
E.g.

Mr. A buys “1 AIG Aug 12 Call at \$1.50”.

1 – number of contract (100shares/contract)
AIG – the underlying stock
Aug – Option expiring month (Option expires on the 3rd Friday of each month)
12 – is the strike price
Call – Call option
\$1.50 is the premium Mr. A pays for this contract. This \$ is stated as per share basis.
So \$1.50 X 100 shares => Mr. A is paying \$150 of premium (excluding transaction fees)

In essence, Mr. A is buying the right to purchase 100 shares of AIG at the price of \$12/share between the point of transaction till the expiry date.

Mr. A pays \$1.50/share (the premium) to attain this right.

OPTION Basics (2) (CALL and PUT)

There are essentially two types of options:

1. Call Option

2. Put Option

For each of the Call/Put, there will be buyer and seller. Let us look into each of the scenario. We will go through “buyer” perspective for both Call and Put before touching on “seller” perspective.

Call Option

Buy Call: When an investor buys a Call, he is buying the right to purchase the underlying stock (100 shares) at the specified fixed price (strike price) by the specified date (expiration) in the future. To re-iterate the examples given.
Example 1:

Mr. A buys “1 AIG Aug 12 Call at \$1.50”.

Mr. A is buying the right to purchase 100 shares of AIG at the price of \$12/share between the point of transaction till the expiry date.

Mr. A pays \$1.50/share (the premium) to attain this right.

So a Call buyer would profit if the share price goes up. A Call buyer is bullish on the stock.

Suppose at the end of the expiration, AIG stock has risen to \$17/share, the buyer would close the transaction and make \$5 gain (\$17-\$12) on the stock, “EXCLUDING” transaction fees and premium paid.
Put Option

Buy Put: When an investor is buying a Put, he is buying the right to “sell” the underlying stock (100 shares) at the specified fixed price (strike price) by the specified date (expiration) in the future.
Example 2:

Mr. A buys “1 AIG Aug 12 Put at \$1.50”.

Mr. A is buying the right to Sell 100 shares of AIG at the price of \$12/share between the point of transaction till the expiry date.

Contrary of buyer of Call, the buyer of Put is bearish of the stock. A Put buyer would profit if the share price drop.

Suppose at the end of the expiration, AIG stock has dropped to \$9/share, the buyer would close the transaction and make \$3 gain (\$12-\$9) on the stock, “EXCLUDING” transaction fees and premium paid.

Next, I will touch on sellers’ perspective for both CALL and PUT.

OPTION Basics (3) (CALL and PUT – Sellers’ Perspective)
Now, we turn our attention towards “sellers” perspectives.

Call Option
Sell Call: When an investor sells a Call, he is selling the right to Call buyer, or granting the Call buyer the right to buy 100 shares of the underlying stock at the striking price from him, any time prior to the expiration. Another way of putting it is the seller is obligated to sell 100 shares of the underlying stock to the Call buyer at the strike price.

Example 1:

Mr. A sells “1 AIG Aug 12 Call at \$1.50”.
Mr. A is selling the right to the Call buyer, say Mr.B, to purchase 100 shares of AIG at the price of \$12/share between the point of transaction till the expiry date from Mr. A.
The call seller, Mr. A would collect the \$1.50/share (the premium).
Suppose at the end of the expiration, AIG stock was traded at \$10/share, the option would expire worthless and the Call seller, Mr.A, would earn the full premium.
So a Call seller is bearish on the stock. He will earn the full premium if the shares expire below the strike price.

Uncovered Calls/Covered Calls
When you sell a call but you do not own 100 shares of the underlying stock, this option is call “naked option”; “uncovered option” or “uncovered call”. This type of trade is extremely risky as the share price could have unlimited up side.
Given the earlier example:
Mr. A sells “1 AIG Aug 12 Call at \$1.50”.

Suppose the share of AIG has gone up to \$30/share. The buyer exercises the option. Mr. A needs to buy 100 shares of AIG from the market at \$30/share and sell them to the Call buyer at \$12/share.

Thus for Call seller, it is always good to own 100 shares of the underlying stock.

So when you own the 100 share of the underlying stock and when you sell the Call, you are covering your position. Such trade is called “Covered Calls”
Put Option

Sell Put: When you sell a Put, you are granting the Put buyer to sell you 100 shares of the underlying stock at the strike price. Should the Put is exercised, you are obligated to buy 100 shares from the Put buyer.