How call options work
Let’s assume you believe that shares of Company XYZ will move from $20 to $30 in the next six months, and you want to make money based on your belief. The obvious way to invest is to buy shares of stock at $20 and hope they increase in value to $30. If the stock increases in value as you expect, you'd earn a profit of $1,000 for every 100 shares you bought, which translates to a 50% return on your investment. Not bad.
Call options give you another way to profit if the stock price rises. We’ll assume that call options with a strike price of $20 are trading for $2 each, and expire in six months. Buying these options would cost $200, since one options contract covers 100 shares. Purchasing these options gives you the right to purchase 100 shares of Company XYZ for $20 per share at any point over the next six months.
If you're right about what the price does, you can make a lot of money with call options. If the stock rises to $30 before the expiration date, your call options would be worth $10 each. (Each option gives you the right to buy a share of stock worth $30 for just $20 per share, so each option is worth $10.)
After subtracting the $2 cost per share to buy the options, your total profit on one call option (100 shares) would be $800. Making a $800 profit on a $200 investment is a return of 400%.
Of course, not all options trades work out so perfectly. In order for the call options to make any money, the stock has to rise to at least $22 per share in that six months. We can calculate this "breakeven price" by adding the premium paid for each option ($2) to the strike price ($20), for a breakeven price of $22 per share.
If shares of Company XYZ increased in value, but only to, say, $21 per share, the call options would result in a loss. If the stock is worth $21, the right to buy the stock for $20 is only worth $1 per option, less than the $2 you paid. This is one reason stock options are much more speculative than simply buying the stock. You can lose money with call options even if the value of the stock increases.
On the other hand, call options also have one major advantage over simply buying shares of stock: The potential losses are limited to the price of the option. Even if Company XYZ falls to $0 per share, the most you can lose is the $2 per share you paid for your options.
It's also worth noting that investors can sell call options as well as buy them. If you own 100 shares of a particular stock, for example, you can sell a call option that gives someone else the right to buy your shares at a certain price. This is known as selling a "covered call."
How put options work
A put option gives the owner the right, but not the obligation, to sell a stock at a predetermined price before its expiration date. Therefore, a put option is profitable when a stock falls below the value of the strike price minus the cost for each option.
Let's say you believe shares of Company XYZ will fall from $20 to $15 in the next six months. The typical way to profit on this wager is to sell the stock short (borrowing shares to sell, hoping to buy them back later at a lower price). If you sell it short at $20 and shares fall to $15, you have a $5 profit for each share you sell short.
Put options give you an alternative. We'll assume that put options with a strike price of $20 are trading for $2 each and expire in six months. Buying one contract (100 shares) costs $200. By purchasing a contract, you have the right to sell 100 shares of Company XYZ for $20 per share any time over the next six months.
If you're correct and the stock drops to $15 by the expiration date, your put options are worth $5 per share. (You then have the right to sell the $15 stock for $20.) After subtracting the cost of each option ($2), your total profit on one option contract would be $300, a 150% return on the $200 you spent to buy the put option.
Just like we did for call options, we can calculate the "breakeven price" by subtracting the premium paid for each option ($2) from the strike price ($20), for a breakeven price of $18 per share. If the stock is higher than that price at expiration, you lose money. And if the stock price is more than $20 at expiration, the option expires, worthless.
Just like call options, put options also cap your potential losses if the stock moves in the wrong direction. If Company XYZ stock rises in value to $60 per share, for example, buying put options would result in a much smaller loss than shorting the stock.
It's also worth noting that investors can sell put options as well as buy them. If you have a positive outlook on a stock that you wouldn't mind owning at a lower price, you can sell a put option that gives someone else the right to sell you shares at a certain price. This is known as a "short put" position, or as a "cash-secured put," because you're typically required to maintain enough cash to buy the shares if the put option is exercised.
Call options vs. Put options
