How Do Put & Call Options Work in the Stock Market?
Stock options provide investors with the future privilege of either buying or selling a security at a set price. If you choose not to exercise your option to buy or sell during the term of the contract, no transaction is made beyond the initial fee you paid. An option to sell is called a "put" and an option to buy is referred to as a "call."
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Description
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An option is the right, but not the obligation, to buy or sell a security at a set price, which is called the strike price. The fee you pay for this privilege is called the premium. The contract for the option runs for a specified term that can be up to three years. If the you exercise the right to make the transaction, the option's writer is obligated to complete the other end of the deal. The types of securities that can be covered by options include stocks, bonds and real estate.
Purpose
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Options are a means of capitalizing on the upward or downward movement of the value of a security without actually owning it. Option premiums are less than the value of a stock's share, so buying an option provides a degree of leveraging as the gains and losses due to price movement are magnified by the smaller investment. Options also limit the amount of risk involved for the buyer, which is never more than the amount of the premium paid. If the price goes the wrong direction you can simply walk away from the deal.
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Put
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A "put" is an option that gives you (the buyer) the right to sell a security. If the price of the security drops you make money by selling the stock at the strike price, which will then be higher than the actual value. If the value rises you can abandon the option and lose only your initial premium.
Call
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A "call" gives you the right to buy securities. If their value rises above the strike price you can execute the trade and pocket the difference. If the price drops you can decline the option and lose only your premium.
Trading
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Options are bought and sold on the major securities exchanges. In the U.S. they are traded through a holding company called the Options Clearing Corporation (OCC), which is registered with the Securities and Exchange Commission to issue and guarantee all options.
Strategies
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The simplest strategy involves single puts and calls that offer potential gains with limited risk to investors who correctly predict the direction of change in a security's price. There are a myriad of more complex strategies. By purchasing or writing different combinations of puts and calls, you can control the potential risk and reward of your trades and have the opportunity to make money in almost any market.
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References
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