Calls and puts: rights and obligations

An option locks in a price for a small fee

What is an option? Start with a deal you already understand. Say Maria wants her neighbor's car for $10,000. She needs a month to get the money, and someone else might offer more.

So she pays her neighbor $200 to hold that price for 30 days. That deal is an option. An option is a contract that gives you the right to buy or sell something at a set price, until a set date. Here, that something is a stock.

The $200 is the premium. The premium is the price you pay for the option. The $10,000 is the strike price. The strike price is the set price you can buy or sell at.

The 30 days end on the expiration date. Expiration is the last day you can use the option. If car prices jump, Maria still buys at $10,000. If she changes her mind, she walks away. She loses the $200 and nothing more.

The premium isn't a down payment. If Maria uses the option, she still pays the full $10,000. An option is the right to buy or sell at a set price, until a set date. You pay a premium for it.

A call is the right to buy, a put the right to sell

Options come in two kinds: calls and puts. Which one is which? An option is the right to buy or sell a stock at a set price, until a set date.

A call is the right to buy a stock at the strike price. The strike price is the set price written into the option. Maria's car deal was a call, the right to buy at $10,000. A call buyer wants the price to rise.

A put is the right to sell a stock at the strike price. It works like insurance. Say Tom owns a stock trading at $50. He buys a 50 put. If the stock falls to $30, he can still sell at $50.

So a put buyer wants the price to fall. Bullish means you expect a rise. Bearish means you expect a fall. Call buyers are bullish, and put buyers are bearish.

The slip is thinking every buyer is bullish. A put buyer bought, but wants the stock to fall. A call is the right to buy at the strike price. A put is the right to sell at the strike price.

Buyers have rights, sellers have obligations

Every option has two sides. One gets a choice, and one gets a duty. The buyer pays the premium, the price of the option. In return, the buyer gets a right, a choice to use or skip.

The seller, also called the writer, collects the premium. In return, the writer takes on an obligation, a promise to keep. Back to Maria. She paid $200, so she has the right to buy the car. Her neighbor took the $200, so he must sell if she asks.

Using the right is called exercise. Maria exercises when she says, I'll take the car. Being told to keep the promise is called assignment. The neighbor is assigned, so he must sell.

With stock, an assigned call writer must sell at the strike price. An assigned put writer must buy at the strike price. Long means you bought the option. Short means you sold it, so you're the writer. The writer wants the opposite of the buyer.

Two slips. Writers don't choose, because buyers do. And exercise happens at the strike price, not the market price. Buyers pay the premium and get the right. Writers collect the premium and take on the obligation.

Worked example: Who must do what?

1. Here's how the exam writes it. Ann buys 1 ABC May 40 put at 2. Ben is the writer.
2. Read it left to right. One contract covers 100 shares of ABC. It expires in May. The strike price is 40, and the premium is 2 a share.
3. The premium is quoted per share, so Ann pays 2 times 100, which is $200. Ben collects that $200.
4. A put is the right to sell. So Ann has the right to sell 100 shares at 40. Ben must buy them at 40 if he's assigned.
5. Now ABC drops to 33. Ann exercises, because selling at 40 beats selling at 33. Exercise means the buyer uses the right.
6. Ben is assigned. Assignment means the writer must keep the promise. He buys 100 shares at 40, even though they're worth 33.
7. Ann paid the premium, so she got to choose. Ben collected it, so he had to perform.

Common mistakes

Buyer or writer? Ask who paid

Mixed up rights and obligations? Ask one question: who paid the premium? The buyer paid the premium, so the buyer gets the right and chooses. The writer was paid the premium, so the writer must perform if assigned. Buyers choose, and writers perform.