What Are Stock Options?

Stock options are financial tools classified as “derivatives” and bought and sold on the “Derivatives Market”. They are called derivatives because while contracts have no inherent value, the value of the option is derived from an underlying asset.

What are Calls and Puts?

There are two options you can buy: Calls and Puts. A call is a contract that states the right to buy an asset at a set price that is locked in until a future date. A put is a contract that states the right to sell an asset at a set price that is locked until a future date.

Note - These contracts give the buyer the RIGHT to buy/sell, not the obligation. Only futures and forwards contain the obligation.

Additional note - Each contract can be described as being American or European style. European style options require the buyer to wait until the expiration date to execute the option while the American style options allow the buyer of the contract to execute whenever they’d like to before and on the expiration date. Because of this added flexibility, you may expect higher premiums on American-style options.

Side note - Whether an option is American or European style is independent of continent. European-style options are made in America and vice versa. Just because you bought an options contract from a European exchange doesn’t mean it’s European-style.

Buying and Selling the contracts

Each contract has two sides: “Long” which means buyer-side or to buy the contract, and “Short” which means seller-side or to sell/write the contract.

Putting it together!

To speak the lingo of an options trader, you’d say you have a “Long Call Position” if you have bought the right to buy a stock at a set price in the future. If you have a “Short Put Position” you are then selling a contract for the right to sell to someone else. This is where people get mixed up. If you have a “Long Put Position”, you are buying the right to sell at a set price, and if you are selling the right for someone to buy at a set price (Short Call Position), both positions are considered “Short Positions” because you’re speculating the underlying asset will decrease in value. You will make money if the value of the underlying position drops in value.

Example:

You buy a put option allowing you to sell 100 shares at $12 (Strike Price or “K”).

Well because you now have the right to sell 100 shares at $12, you want the stock price (ST) to drop below $12 so you can make money. If the price of the stock drops to $10 per share, you can execute your put option and make the difference of $2 per share, giving you a payout of $200. I say payout because this isn’t necessarily profit. I haven’t told you this yet but options come with a premium attached to give the issuers some incentive for making/writing the option contract.

Suppose to buy the put, you pay a premium of $35 [FV(p)].

To calculate the profit of Long Put Options, you’d use: Profit = (K-ST)-FV(p)

Side note: If you’re position is selling the contract, you simply put a negative sign in front:

Profit = -[(K-ST)-FV(p)] or Profit = -(K-ST)+FV(p)