What is an Option? Put Option and Call Option Explained
The Chicago Board Options Exchange defines an “option” as follows: There are many ways a stockbroker can violate legal and ethical obligations to a customer, and in most cases, the broker’s
An option is a contract giving the buyer the right, but not the obligation, to buy or sell an underlying asset (a stock or index) at a specific price on or before a certain date (listed options are all for 100 shares of the particular underlying asset). An option is a security, just like a stock or bond, and constitutes a binding contract with strictly defined terms and properties.
For most casual investors, that definition may as well be written in ancient Greek. And yet brokers sometimes buy and sell options for investors who don’t understand what they are, can’t appreciate or afford their risk, and may not even know that the option transactions are occurring.
Put Options and Call Options
Perhaps we can explain options a bit more clearly.
There are only two kinds of options: “put” options and “call” options. You’re likely to hear these referred to as “puts” and “calls.” One option contract controls 100 shares of stock, but you can buy or sell as many contracts as you want.
When you buy a call option, you’re buying the right to purchase from the seller of that option 100 shares of a particular stock at a predetermined price, which is called the “strike price.” You have to exercise your call by a certain date or it expires. To purchase a call option, you pay the seller of the call a fee, known as a “premium.” When you hold a call option, you hope the market price of the stock associated with it will increase in the near future. Why? If the stock price increases enough to exceed the strike price, you can exercise your call and buy that stock from the call’s seller at the strike price, or in other words, at a price below the stock’s market value. Then you can either keep the shares (which you obtained at a bargain price) or sell them for a profit. But what happens if the price of the stock goes down, rather than up? You let the call option expire and your loss is limited to the cost of the premium.
When you buy a put option, you’re buying the right to force the person who sells you the put to purchase 100 shares of a particular stock from you at the strike price. When you hold put options, you want the stock price to drop below the strike price. If it does, the seller of the put will have to buy shares from you at the strike price, which will be higher than the market price. Because you can force the seller of the option to buy your shares at a price above market value, the put option is like an insurance policy against your shares losing too much value. If the market price instead goes up rather than down, your shares will have increased in value and you can simply let the option expire because all you’ll lose is the cost of the premium you paid for the put.
Purchasing options can give you a hedge against losses, and in that sense, they can be used conservatively. But there are many options strategies that amount to little more than gambling and can increase your risk to a frightening degree. One simple example is the sale of “uncovered” calls. Remember, when a call is exercised, stock must be delivered by the seller of the call. If you’ve sold that call on stock you already own, the call is “covered” by those shares and your cost has already been incurred. If the option is exercised, you’ll simply deliver those shares to the option holder. But if you sell an “uncovered” call, meaning you don’t yet own the stock, your potential for loss is unlimited. If the option is exercised, you’ll have to buy those shares on the open market to cover your obligation, no matter how high the price may be at that time. If a strong market advance or a major announcement by the issuer has driven the share price up sharply, your losses could be enormous.
As indicated, many option strategies involve great complexity and risk. For this reason, not all options strategies will be suitable for all investors. In fact, with the exception of sophisticated, high net worth individuals who can afford and are willing to incur substantial losses, the writing of puts or uncovered calls would be unsuitable for just about everyone. Nevertheless, brokers sometimes engage in inappropriate options trading on behalf of customers who do not understand the risks.
If you have lost assets because your stockbroker was engaging in options trading, please contact us today.