Options trading basics begin with understanding what an option is. It is a contract. That’s it. It’s a contract between two parties to exchange something.
What are they exchanging? Risk. Capital markets are risky by nature. Stocks go up, stocks go down– sometimes they crash. Due to this risk, some investors want to remove some of that risk, and are willing to pay a risk premium for it.
Since options are a contract, there will always be two sides to each trade. Therefore, in options trading, there will be an option buyer, and an option seller. The buyer is looking to pay a premium to transfer risk. The seller is willing to accept that risk for a certain premium. Because there are so many stocks and so many kinds of options, it makes sense to standardize the contracts. For most options, the standard size of the contract is 100 shares.
Options generally involve calls and puts.
Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless.
Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ”writing” an option. Writing covered calls is a way of generating income (i.e., when the call writer owns the underlying stock which she is selling calls against).
Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires.
Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise.
Put buyers – those who hold a “long” – put are either speculative buyers looking for leverage or “insurance” buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a “short” expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlying asset is at or above the option’s strike price at expiration. The maximum loss is unlimited for an uncovered put writer.
Options trading can be understood better by reading our discussion of the fundamental difference between puts and calls here.