An option contract is an agreement where the owner has the right to buy or sell a security or particular price on a fixed date in the future. It is called an option because the owner of the contract is not committed to carry out the obligation of the contract if he or she feels that it is not to there advantage.

Options contracts come in two forms: call options and put options.

Call Options

In simple terms, call options give the owner the right to buy the underlying asset in the contract. Again, it is not an obligation.

For example, Helen and Terry agreed on a call options contract wherein Helen will buy from Terry, 1000 shares (equivalent to one option) of Company YZ at $20 (strike price) which will expire on the last Thursday of April. The current price of the share is $20.

At the expiry date (also called maturity date), the share price of Company YZ remains at $25. Helen can then exercise her right to buy the share for $20 and thus, yielding $5. Meanwhile, if the share price goes down to $22, Helen can still earn $2 by simply exercising her rights as stated in the contract. In whichever way, any amount higher than the strike price at the end of the contract will become the profit of the owner. But before it can happen, the owner who decides to pursue his right has to have his money ready to pay for the amount.

However, if the share price goes down below $20, say $18, on the maturity date, it will be too expensive for Helen so she can just ignore the contract since she is not obliged to carry it out. She will only lose the amount she paid for the contract called the Option Premium. Terry, on the other hand will keep the asset and the premium, which in a sense, is his profit.

Put Options

In put options, the buyer has the right to sell an asset to the writer (the seller). Just like the call asset, it is bounded by a contract which states that the underlying asset will be sold at a particular price and a particular date. But the similarity ends there. In put options, the writer has to buy the underlying asset at the strike price if the buyer exercises this option.

Let us continue with Helen and Terry. Helen bought call options from Terry. But she could also buy put options from Terry. If Helen buys put options, it means that she buys the right to sell Company YZ's shares at $20 on April 1. If the price of shares goes down below $20 on the expiry date, Helen can exercise her right and can still sell it at $20, thus making a profit.

Buying put option allows investors to earn when price of shares drops at the end of the contract.

Profit potentials are unlimited for the buyers of put options, especially if the market begins to sell off. On the other hand, risks are limited if the market goes against them.

Important note:

In reality, trading of options or transactions does not happen between two persons. Buying or selling can happen without knowing the identity of the other party.

Options are only sold in 1000 share lots. So if the share price is $20, you will have to pay $20,000 for each option contract plus the Option Premium.