The Basics of Option Contracts (Call Options, Put Options, and Terminology)

This post provides a very basic background before I discuss a recent trade I executed that will be covered later this week:

Basic Option Terminology

Options are a type of derivative contract because their value is derived from an underlying security (in this case, shares in a company). Option contracts represent an action that can be carried out on underling shares at a time in the future. A European option can only be exercised (executed) on its day of expiry, while an American option can be exercised any time until or on the day of expiration. A call option contract (a usual option contract represents 100 shares of stock) represents the right but not the obligation to purchase shares of stock in the future at a specified price, called the strike price. A put option represents the right but not the obligation to sell shares of stock at a strike price in the future as well.You must pay a premium to purchase any option. Option contracts are traded on several different exchanges, and their value or price (the premium amount) is determined by supply and demand just like in any other securities market.

Option Profitability

On a basic level, profit or loss from an option contract can be determined by the difference between the stock price and the strike price. As an example, say you buy  a call option on Apple (ticker: AAPL) that is valid until June 24, with a strike price of $270. On June 24, if the price of AAPL stock is above $270, the option is profitable, which is also known as in the money. You could exercise the call option (carry out the contract) and purchase the AAPL shares for a lower price than their current market price at that time. If you had bought a put option on AAPL, and the market price was below the strike price, then you would also have a profitable contract on your hands. However, if the price were above the strike price, your option would expire worthless (because why would you sell your stock at a lower price than you could in the market?). A option contract that is currently not profitable is known as a out of the money contract. A option whose strike price matches the market price is considered at the money

For more detailed information on the Profit and Loss from different types of option contracts, including taking into account the premium you must pay, I would take a look at the tutorials on Wikipedia:

More Info on Buying a Call Option and Selling (Writing) a Call Option | on Buying a Put Option and Selling (Writing) a Put Option

Trading Option Contracts

You can buy options that are in the money, out of the money, or at the money. An in the money option acts very much like the underlying shares in terms of its price movement. An out of the money option requires greater movement in the underlying share price to move. And at the money contracts are the most sensitive to prices changes in the underlying share value.

Options can be analyzed using what are known as "the Greeks": the Delta, Gamma, Vega, and Theta (more on these in an upcoming post).

Any combination of put options, call options, and even already holding the underlying shares can be used to execute several different types of option strategies, depending on whether you think the underlying share price will go up, go down, or have relatively neutral movement.

Why Options Are So Seductive

In one word, leverage. For far less than the cost of actually owning stock, you can control large amount of shares via option contracts. You can imagine how the profit (and loss) can multiply as each option contract represents the right to 100 shares.

However, it is important to note that options are an zero-sum game. There are two parties involved in every contract, and one party always comes out on top while the other loses everything. If an option expires out of the money, you lose everything while whoever sold you the option gets to keep your premium. The zero sum nature of options is why they are considered so risky. When an option expires worthless, you have lost all your money, where as if you were to own actual shares you can always continue holding on for the value to go back up.