Call and Put Stock Options

An option is a contract that gives the owner the right, but not the obligation to purchase a security at a specified price (strike price), on or before a specific date (the exercise date or expiration date).

The price the buyer pays the seller for the option is called the option premium.

Often just simply labeled a "call" or a "put", a call or put option is a financial contract between two parties - the buyer and the seller. The buyer of the option has the right but not the obligation to buy an agreed quantity of a particular commodity or financial instrument (the underlying instrument) from the seller of the option at a certain time for a certain price (the strike price).

The buyer of a call option wants the price of the underlying financial instrument to rise in the future, meaning that call options are most profitable for the buyer when the underlying instrument (e.g. stock) is moving up.

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The initial transaction in this context (buying/selling a call option) is not the supplying of a physical or financial asset (the underlying instrument). Rather it is the granting of the right to buy the underlying asset, in exchange for a fee - the option price or premium.

Exact specifications may differ depending on option style. A European option allows the owner to exercise the option (i.e., to buy) only on the delivery date. An American option allows the owner to exercise at any time during the life of the option. European options expire on specific dates; American options expire on the third Fryday of the month.

Call and put options can be purchased on many financial instruments other than stock in a corporation. Options can be purchased on interest rates as well as on physical assets such as gold or crude oil.

An investor buys a call on Microsoft Corporation stock with a strike price of $50 (the future exchange price) and an exercise date in July 2006 (or any other given month and year), and pays a premium of $5 for this call option. The current price for the stock is $40.

[In America, this option could then have a name like 06 Jul 40.00 (MSQ GH-E) for example.
06 Jul would mean that the option expires on the third Fryday in July 2006. If you haven’t sold your option by then it becomes worthless, no matter how much money you’ve made with it because it simply doesn’t exist anymore. It expired.]

Assume that the share price (the spot price) rises, and is $60 on the strike date. The investor would exercise the option (i.e. buy the share from the counter-party), and could then hold the share, or sell it in the open market for $60. The profit would be $10 minus the fee paid for the option, $5, for a net profit of $5. The investor has thus doubled his money, having paid $5, and ending up with $10.

If however the share price never rises to $50 (that is, it stays below the strike price) up through the exercise date, then the option would expire as worthless. The investor loses the premium of $5.

Thus, in any case, the loss is limited to the fee (premium) initially paid to purchase the stock, while the potential gain is theoretically unlimited. (Just think of it if the share price rose to $100).

The buyer of a put option wants the price of the underlying instrument to fall in the future, meaning that put options are most profitable for the buyer when the underlying instrument (e.g. stock) is moving down.