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October 29, 2010 (Revised Ed.) - by Christopher Smith
  
Overview of Stock Options

Discover how a put and call option work and the difference between the two.

An option is a contract to buy or sell a specific financial product; e.g., IBM stock. The specified financial product is referred to as the option's "underlying instrument" or underlying interest. The underlying instrument for equity options is a stock, exchange-traded fund (ETF), or other similar product.

Option contracts are standardized and very precise. Each contract specifies a "strike price", which is the the price at which the underlying instrument may be purchased or sold. The contracts each have an "expiration date", which is the day on which the option expires and thereafter ceases to exist.

There are only two basic types of options: Call options and Put options.

Buying and Selling Call Options & Put Options

The situation is different if you "write," or sell, an option. Selling obligates you to fulfill your side of the contract if the holder wishes to exercise.

If you sell a call, you're obligated to deliver the underlying security to the call option holder at the specified strike price, if you're assigned. In other words, you are obligated to sell the underlying stock at the specified strike price even if the stock has moved higher in price.

If you sell a put, you're obligated to buy the underlying security, if assigned. For example, if you sell a put option on XYZ stock and the stock drops in value below the strike price, you will be obligated to buy the stock at the strike price even though it is trading in the market for a lower price.

However, just as the buyer can sell an option back into the market, an option writer can purchase an offsetting option contract and end their obligation to meet the terms of the contract.

As an option seller, or an option "writer," you have no control over whether an option contract is exercised. You must recognize that exercise is always possible until the option expires on its expiration date.

Stock Option Premium

When you buy an option, the purchase price is called the premium. If you sell an option, you receive payment of the option's premium as a cash credit to your account.

The premium is not fixed and changes constantly due to several factors.  What those changing prices reflect is the give and take between what buyers are willing to pay and what sellers are willing to accept for the option. The point at which there's agreement becomes the price for that transaction, and then the process begins again.

If you buy options, there is a net debit to your account. That means you've spent money you might never recover if you don't sell your option at a profit or exercise your rights under that contract. 

As an option seller, you receive a net credit to your account because you collect the premium. If the option is never exercised, the option will expire and you will keep the money with no further obligation to fulfill. If the option is exercised, you still get to keep the premium, but you will be obligated to buy or sell the underlying stock if you are assigned.

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