Options can be versatile and flexible, with trading opportunities for any market type—up, down, or sideways. Options strategies can range from relatively simple to very complex, but they are all based on the two basic types of options: the call and the put.

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Agreements Between Buyers and Sellers

You may have had the experience of buying car insurance for your car. Legally speaking, car insurance is an agreement between you and the insurance company. After you pay the premiums, you are covered from certain risks, because the insurance company agrees to pay you for losses.

An options contract is also an agreement between two parties.

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• An options buyer has the right, but not the obligation, to buy (call) or sell (put) stock shares of a specific asset at a specific strike price on or before a specific expiration date.
• In contrast, the options seller is obligated to trade the shares with the buyer. A call seller must SELL the underlying shares at the strike price if the call is exercised, and a put seller must BUY the underlying shares at the strike price if the put is exercised.

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Of course, the option buyer's right comes with costs: they have to pay the premium to the seller, just as you pay for your car insurance.‌

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Let's look at a few common characteristics that all options contracts have. Knowing them helps you understand how options differ from stocks:

①. All options have an underlying security, meaning the assets to be traded.

②. All options have an expiration date, the date on or before which they can be exercised.

③. All options have a "Strike Price," the price at which the underlying security is traded if the option is exercised.

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When we put these three characteristics together, we can see what an option contract looks like. If our underlying is ABC, our strike price is $150, and our expiration date is July 15th, our contract might look something like this: [ABC 15 July 150 Call]

So far, we understand the core characteristics of an options contract. Let's build on our knowledge and discuss the two different types of options: Calls and Puts.

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A Bullish Strategy: Buying Calls

‌If an investor believes a stock is going to go up past a certain price on or before a certain day, he may use this strategy. The potential upside profit of this trade is uncapped if the stock soars. The maximum loss is limited to the premium paid on the call option. So, how does a call option work?

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For example, let's say ABC stock is trading around $10.24. You're bullish on ABC, so you buy 1 ABC Call with a strike price of $11 expiring on 16 Sep 2022. The option premium for the contract is $0.62. What are your risks and rewards if you hold it to expiration?

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i. Your maximum gain is unlimited since there is no cap on how much the stock price could increase. In that case, you can buy a more valuable stock at a lower cost.

ii. The breakeven point is $11.62 ($11 strike price + $0.62 option premium paid), so you are hoping that ABC's stock price rises above $11.62 before or on the expiration date.

iii. Your maximum loss is the amount you pay for the contract, $62 ($0.62 option premium x 100 shares).

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‌When to use it: A call-buying strategy can be a good choice when you expect the stock to rise significantly before the option expires. If the stock price rises only slightly above the strike price, the payoff on the option may not even make up for the premium paid, leaving you with a net loss.

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A Bearish Strategy: Buying Puts

‌If an investor believes a stock is going to drop below a certain price on or before a certain day, he may use this strategy. Unlike the call-buying strategy, the potential upside profit of this trade is realized as the stock goes toward zero. The upside of this strategy is not unlimited but is still considerable. The maximum loss is limited to the premium paid on the put option.

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Suppose another investor is bearish on ABC. So, he buys 1 ABC Put with a strike price of $11 expiring on 16 Sep 2022. The option premium for the contract is $1.22. He can estimate the risk and rewards of holding it to expiration.

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i. His maximum gain is realized when the stock goes to zero and would be $978 ($11 - $1.22 option premium = $9.78, x 100 shares). At that time, he can sell worthless shares at a higher strike. However, a stock cannot go below zero.

ii. The breakeven point is when the stock trades at $9.78 ($11 strike price - $1.22 option premium paid), so he is hoping that ABC's stock price drops below $9.78 before or on the expiration date.

iii. His maximum loss is the amount he paid for the contract, $122 ($1.22 option premium x 100 shares).

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‌When to use it: A put-buying strategy can be a good choice when you expect the stock to fall significantly before the option expires. If the stock falls only slightly below the strike price, the payoff on the option may not even balance the premium paid, handing you a net loss. Buying puts is another simple and popular way to wager on a stock's decline.

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Let's Recap

The basic call and put options described above are just the beginning. There are many different ways you can use options. Don't forget to take a look at the quiz below to test yourself.

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