Call And Put Options Can Make You Money
In the realm of stock options there are two types: puts and calls. They are almost the same except that one is for buying and the other is for selling.
Put options are normally bought when an investor thinks a stock will fall in price. It gives the investor the right to sell shares at a certain price by a certain date. Likewise, call options are normally purchased when the investor believes the stock will rise — it gives him the ability to buy the stock at a known price before a known date. Puts and calls are very similar in that they both have an underlying stock, a price, and a date associated with them. But puts represent the right to sell, while calls represent the right to buy.
With regards to expiration dates on options, there are two styles: American and European. With American style the holder of the option may exercise his right on any day prior to (and including) the expiration date. With European style options, the holder may only exercise his right on the expiration date. Sometimes with American style options the holder will exercise early (called ‘early exercise’) to capture a dividend that is about to be paid.
A critical attribute of any option is its strike price because that is the price that the two investors in the trade have agreed to. If the stock finishes above the strike price (for call options) on expiration day, or if the stock finishes below the strike price (for put options) on expiration day, then then holder of the option will exercise his right to buy (for calls) or sell (for puts) the stock. In the case of a call option, if the stock is below the strike price then it doesn’t make any sense for the holder to exercise his right to buy at the strike price; it would be cheaper to just go into the open market and buy shares at the market price. But if the stock was above the strike price then he would be better off exercising his option to buy the shares at the strike price.
The price of the option is comprised of two parts: intrinsic value and time premium. If the call option is out of the money (meaning the current market price is below the strike price) then the entire option price is time premium. But if the call option is in the money (meaning the current market price of the stock is above the strike price) then the intrinsic value is the difference between the stock price and strike price, and then the time premium is the difference between the option price and the intrinsic value.
Calls and puts can be used for rapid gains in a short period of time. If an investor believes a stock will rise quickly then he would buy a call option. If he guesses wrong, though, then he could lose all of his investment by the expiration date of the option. Likewise, if an investor thinks a stock will go down in a short period of time then he could buy a put option. If the stock does finish lower than the strike price by expiration then he may have a profit (depends on how much he paid for the put).