Understanding Options: Part 1 - Buying Option Contracts

Options are essentially contracts to buy and sell shares of underlying shares that they represent. There are two kinds of stock options, puts and calls. In part I, I want to talk specifically about buying options, which is the safest and least risky way of entering into an options contract. Keep in mind that buying options can actually hinder your profit potential, since options are depreciating contracts.

Puts give the put owner a right to sell a stock at a given strike price, if the stock's market value is at or below the striking price at the time of expiration.

Example - Stock XYZ is at $10, and a put buyer buys the 5$ strike put for XYZ, perhaps as downside protection. Unless XYZ drops to at or below 5$ before expiration, the buyer cannot exercise the option contract. If it does, then the buyer can opt to sell XYZ at 5$. This method assumes the put buyer owns the underlying stock.

Benefit - If the stock tumbles to less than 5$, the owner of XYZ 5$ puts can sell for 5$, attenuating any deeper losses that might be faced. This is similar to a stop-loss order, however, it's more hedged against time.

Calls give the call owner a right to buy stock at a given strike price, if the stock's market value is at or above the striking price at the time of expiration.

Example - Stock XYZ is at $10, and a call buyer speculates that it will climb to $20. Buyer then purchases a $15 strike call as a speculative move and waits for expiration. The buyer cannot exercise the option unless the underlying stock is valued at or above $15.

Benefit - If the stock is valued at above 15$ at the time of expiry, then the buyer gets to buy the underlying XYZ stock for 15$, which is under the market value. Buyer can then dump the stock right away at a profit, or hold on to the underlying speculatively and perhaps sell calls.