Options, Explained Simply

What call and put options are, how they can be used to protect investments or to speculate, and why most buyers of short-term options lose money.

An option is a contract that gives its buyer the right, but not the obligation, to buy or sell something at a set price before or on a certain date. Options are traded on shares, stock indices, currencies and commodities.

Calls and puts

A call option gives the right to buy at a set price, called the strike price.
A put option gives the right to sell at the strike price.

The buyer pays a price for the option called the premium. The seller, or writer, of the option receives the premium and must fulfil the contract if the buyer uses it.

How a call works

Suppose a share trades at 100. You buy a call option with a strike price of 110, expiring in one month, for a premium of 3. If the share rises to 125, you can buy at 110 and the option is worth 15, a profit of 12 after the premium. If the share stays below 110, the option expires worthless and you lose the 3 premium.

Uses of options

Hedging: an investor who owns shares can buy put options as insurance against a price fall.
Income: investors who own shares can sell call options to earn premiums, giving up some potential gains.
Speculation: traders buy options to bet on price moves with a small upfront cost. Because a small premium controls a larger value of shares, gains and losses in percentage terms can be very large.

Options as insurance

An investor owns shares worth 1,000,000 rupees and is worried about a fall over the next three months. She buys put options that let her sell at 950,000 rupees, paying a premium of 20,000 rupees. If the market crashes and her shares fall to 700,000 rupees, the puts make up most of the loss. If the market rises, she loses the premium, like paying for insurance she did not need.

The risks

Many short-term options expire worthless. Buyers must be right not only about direction but also about timing and size of the move. Sellers of options face potentially large losses if prices move sharply against them. Studies of retail options trading in several countries have found that most individual traders lose money.

Thinking options are a cheap way to get rich

The low cost of an option makes it look like a cheap bet with huge upside. In reality, the premium reflects the chance that the option will pay off, and most short-term options bought by individuals expire worthless. Options are powerful tools for hedging but risky for speculation.

Key takeaways

An option gives the right, but not the obligation, to buy or sell at a set price.
Calls give the right to buy; puts give the right to sell.
Options can hedge risk, generate income or speculate.
Most short-term options bought by individuals lose money.