How Do Options Work?

A call option gives an investor the right to buy 100 shares of a particular security at a predetermined price (the strike price) before a set deadline (the expiration date). A put option gives an investor the right to sell 100 shares of a particular security at a predetermined strike price before a set deadline. An investor can purchase both put and call options, or sell (write) both put and call options. An investor who writes a put option is giving another investor the option (but not the obligation) to force the put writer to purchase a security at the strike price before the expiration date. An investor who writes a call option is giving another investor the option (but not the obligation) to purchase an underlying security at the strike price before the expiration date.

An investor who writes, or sells, a put or call option collects immediate income. That investor is hoping the option does not get exercised in which case the premium collected is all profit. If the option is exercised, the option writer is obligated to buy or sell the underlying security at the strike price. This could lead to potentially large loss for the option writer.

An investor who purchases a put is seeking protection from a decrease in value of the underlying security. An investor who purchases a call is attempting to capitalize on an increase in value of the underlying security. Purchasing a call usually requires only a small investment. If the call is exercised, it may results in a large return for the investor. If the call expires without being exercised, the call purchaser suffers a 100 percent loss.

Clearly, options are complex and risky investment tools. One should not invest in these products without a thorough understanding of the risk involved. Additionally, option contracts are usually purchased to supplement a more complete investment strategy. Be sure to speak to an independent fee only financial planner before even considering these investment products.