Call and put option contracts give holders the right to buy or sell the underlying shares at fixed strike prices on or before expiration. The writers, or sellers, of these contracts have the obligation to deliver -- for calls -- or buy back -- for puts -- the shares at their respective strike prices if the option holder decides to exercise his rights. Investors can use options to hedge existing long or short stock positions or to speculate on market price movements.
If the strike price of a call option is below the market price, the option is said to be in the money. The holder can exercise her rights to buy the underlying shares or sell the contracts. The option is out of the money if the strike price is above the market price, in which case option holders can either sell the call options and cut their losses or hold on to the options, hoping that the underlying shares will rally. The premium, or market, price of call options rises and falls with the underlying stocks, but premiums deteriorate faster as the option gets closer to expiration. Selling a put option usually involves writing the contract and simultaneously setting aside the cash to buy the stock if the price of the stock declines below the strike price and the holder exercises the option.
Investors typically buy calls because they expect the underlying shares to rally, betting on substantial profit potential. For example, if a call option's premium rises by 10 cents from 40 cents to 50 cents, the effective profit is 10 cents multiplied by 100 shares, or $10, per contract. In other words, a small investment of $40 per contract results in a 25 percent profit. Investors sell put options to generate income from the premiums received, especially if they expect the stock price to remain above the strike price of the written puts.
The return on investment for a call option is theoretically infinite because the stock price could rise forever. For a put writer, the maximum profit is limited to the premium received. For example, the maximum return for writing put option contracts at 50 cents each is 50 cents multiplied by 100, or $50 per contract. If the market price of the shares stays above the strike price at expiration, the total profit is the premium minus commissions.
The risk of buying a call option is limited to the premium paid. For example, a call option contract with a strike price of $10 purchased for 50 cents would expire worthless if the market price of the stock is $9 at expiration. Investors usually try to sell expiring out-of-the-money options to minimize losses, provided there is a market for these options. The maximum loss for selling a put occurs when the stock price drops to zero and the investor must buy the shares at the strike price. If the shares subsequently rally, investors could reduce their losses over time.
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