An option is a contract that gives you the right to buy or sell 100 shares of stock. (Each option always means one hundred shares.) This right comes with a certain stock and a fixed price per share that won't change until a certain date in the future. When you have an open option position, you don't own any stock and don't owe any money on the stock either. You only have the legal right to buy or sell 100 shares of stock at the fixed price, according to the contract.
You might ask, "Why do I need to buy an option to get the right to buy or sell 100 shares at the current market price?" The answer is that the option sets the price of the stock, which is the key to figuring out the value of an option. Stock prices can go up or down, sometimes by a lot. The price of a stock can go up or down in ways that are hard to predict. This makes investing in stocks interesting and also shows how risky the market is. As the owner of an option, you can buy or sell 100 shares of stock at the same price for as long as the option is valid. So, no matter how much the price moves, if you want to buy or sell 100 shares of that stock, your price won't change. In the end, the value of an option will be based on how the fixed price compares to the current market price of the stock.
Options come with a few important rules:
- The right to buy or sell stock at a fixed price is never permanent. In fact, time is the most important factor, since the option is only good for a certain amount of time. After the deadline, the option is no longer useful and no longer exists. Because of this, the value of the option will fall in a predictable way as the deadline approaches.
- Finally, each option applies to exactly 100 shares of stock, not more and not less.
- Each option also only works for one stock and can't be moved to another.
A round lot, which is a standard trading unit on the public exchanges, is a group of 100 shares of stock that is bought or sold. On the market, you can buy or sell as many shares as you want, as long as they are available and you are willing to pay the seller's price. But if you buy less than 100 shares at once, you will have to pay a higher trading fee. An odd lot is a group of shares with an odd number of shares.
So, whether you are a buyer or a seller, each option applies to 100 shares, which is the most common lot size. You can do one of two things. The call gives its owner the right to buy 100 shares of a company's stock. When you buy a call, it's as if the person selling it to you is telling you, "I'll let you buy 100 shares of stock in this company at a certain price at any time between now and a certain date in the future. I expect you to pay me the price of a call for that right."
When the price of the stock changes, so does the value of each option. If the value of the stock goes up, the value of the call option will also go up. And if the market price of the stock goes down, the call option will do the same thing. When an investor buys a call and the market price of the stock goes up afterward, the investor makes money because the call is now worth more. The value of an option is pretty easy to figure out. It depends on how much time has passed and how much the stock price has changed.
Tip
Changes in the stock's value have a direct effect on the value of the option, since the option's price per share stays the same even if the stock's market price goes up or down. Changes in value are predictable, and it's easy to figure out how much an option is worth.
The put is the second type of option. This is the opposite of a call because it gives the right to sell instead of the right to buy. A put contract gives the person who owns it the right to sell 100 shares of stock. When you buy a put, it's as if the person selling it to you said, "I'll let you sell me 100 shares of stock from a certain company at a certain price per share at any time between now and a certain date in the future. For that, I expect you to pay me the price of a put at the moment."
Calls and puts are easy to understand if you remember that you can buy or sell either option. This means that there are four ways an option transaction could go:
- Buy a call (buy the right to buy 100 shares).
- Sell a call (sell to someone else the right to buy 100 shares from you).
- Buy a put (buy the right to sell 100 shares).
- Sell a put (sell to someone else the right to sell 100 shares to you).
Another way to be sure of the difference is to remember these things: A call buyer thinks and hopes that the price of the stock will go up, while a put buyer wants the price per share to go down. If the belief is true in either case, there could be a profit.
For people who sell options, the opposite is true. A seller of calls hopes that the price of the stock will stay the same or go down, while a seller of puts hopes that the price of the stock will go up. (If the value of the option goes down, the seller makes money.)
Tip
Option buyers can make money whether the market goes up or down. The key is to know in advance which way the market will move.
