Beginners Guide to Options

Buying a call

An option to buy at the strike price (which can be the actual price of the stock or somewhere above or below it).

Example: Say the current share price is £1. And the strike price is also £1. This means you have the option to buy the share at £1 – so if for example the share price goes up to £1.20 you can exercise your right to buy it at £1 and then immediately sell it at £1.20 in theory making 20p per share.

However, there is also a premium added on which you have to pay regardless of whether or not you exercise your option to buy.

So for arguments sake, the premium may be 20p. You pay the 20p per share when you take out the option. This means that in order to make any money, you have to count on the share price going above £1.20 (as the extra 20p will account for the premium you have already paid.

Selling a call

Selling a call means you are on the other side of the above bargain. You charge someone a premium and in return you give them the option to buy the shares from you at the strike price.

If the share has a current value of £1 and over the past year it has stayed between 50p and £1.50 then the premium might be 20p – because if you make the premium too small, then the share only has to fluctuate slightly and the other party will call the option and you would lose money.

When selling a call (also called writing), you are hoping that the share price goes down or stays where it is – so if the strike and the current share price are £1 and the premium is 20p, as long as it stays below £1.20 you will make money – as you will get the premium but the other party will not call the option so you simply keep the premium.

If the shares go to say £1.30 then the Buyer will call the option and you will have to sell the shares to the other party for £1 – so after the premium is accounted for, you will have made a 10p loss per share.

In the buying and selling (writing) a call, it is the buyer has control – he makes the decision whether or not to go through with the option – the seller just has to wait and hope the option isn’t called.

Buying a put

Buying an option to sell the shares at the strike price. You would buy a put if you thought the share price was likely to go down. This is similar to selling a call, the difference is that you have control.

Say for example the share price and strike price are currently £1. You would buy the option to sell the share at £1, you would then pay 20p premium for this pleasure, in the hope that the share price goes down to say 70p in which case, you would effectively buy the shares for 70p and by exercising the option, sell them straight away for £1 – after taking account of the 20p premium you would have made 10p per share.

Selling a put

Once again, selling a put is like being on the other end of the above bargain. You would give someone else the option to sell you shares at the strike price, and you would charge them a premium for this. You would be hoping that the share price either stays the same or goes up, in which case you would simply keep the premium. If however the share price did go down, they could exercise the option and you would have to buy the shares at £1 even though their current value may be only 70p. In which case after taking into account the premium of 20p, you would lose 10p per share.

Strike price

The strike price is not always the same as the current share price. For example, when buying a call, the strike price may be less than the current share price (In the money), or greater than it (out the money).When buying a call, if the strike is higher than the current price, it means the stock must go up further for you to make money, and if the strike is lower than the current price, the stock would in theory not have to go up so much for you to make money – however, in this case, the seller of the call would probably make the premium quite high, to account for this.

If you have any questions before we move on to the next stage, ask them in our Question and Answer section.