Options

The two types of options of interest to us here are  on an underlying asset. We introduce them using option contracts for 100 shares of a stock as the underlying asset.

A put option gives the buyer the right (but not the obligation) to sell 100 shares at a specified price (the exercise price, also referred to as the strike price) for specified period of time, the time to expiration. The put seller (also called the writer of the option) takes on the obligation to purchase the 100 shares at the price specified in the option, if the put buyer exercises the option.

Note the “one-way” nature of options. If the exercise price of the puts is $25 at the expiration of the option, and the shares are trading at or above $25, the put holder will not exercise the option. There is no reason to exercise the put and sell shares at $25 when they can be sold for more than $25 in the market. This is the outcome for any stock price greater than or equal to $25. Regardless of whether the stock price at option expiration is $25 or $1,000, the put buyer lets the option expire, and the put seller keeps the proceeds from the sale.

If the stock price is below $25, the put buyer will exercise the option and the put seller must purchase 100 shares for $25 from the put buyer. On net, the put buyer essentially receives the difference between the stock price at expiration and $25 (times 100 shares).

A call option gives the buyer the right (but not the obligation) to buy 100 shares at a specified price (the exercise price) for a specified period of time. The call seller (writer) takes on the obligation to sell the 100 shares at the exercise price, if the call buyer exercises the option.