An option is the right but not an obligation to convey a piece of property. The person selling or granting the option is called the options seller and the person who has the right to execute option is called the options buyer. The options buyer pays fees (premium) for the options to the options seller.
Options can be in one of two forms:
A call option (often simply named as "calls") is a contract between two parties. The buyer of the call option has the right but not an obligation to buy the underlying assets (stocks) before the expiration date at strike price. The call options seller is obligated to sell the underlying assets if the options seller decided to exercise his/her right.
A trader who buys call options expects the price of the underlying assets (stock) to move up in the future but before the options expire. On the other hand an options seller expects that the price of the underlying assets will drop and call options will expire worthless.
Call options deliver profit when the stock price moves up. Call options called in-the-money if the current underlying assets (stock) price is above the strike price. Out-of-the-money call options are calls with strike price below the current stock price.
The same as call options the put options (simply called as "puts") is a contract between two parties: buyer and seller. The difference is that in case of the put options the options buyer buys the right to sell (not buy as in case with calls) the underlying assets (stock) at specific price and before the specific date. In exchange for this right the options buyer pays premiums to the options seller who is obligated to buy the underlying stock at a strike price if the options buyer decides to exercise the right to sell before the expiration date.
The put options buyer expects the price of the underlying stock to drop, while the put options seller would profit on the rising market. In Bear market the put price is rising and in the Bull market, the put price is dropping.
The most popular and widely-known options are options a particular company shares (stock options). However, you may find the options that are traded on many other assets: currencies, interest rates, gold, crude oil, etc
Speculation is the main reason that many traders become involved in the options market. This is why options trading has become so popular. The great leverage offered in options trading attracts speculators who are willing to accept the risk of investing in a trade (where 100% of the investment could be lost) in exchange for an opportunity to obtain greater and quicker returns (where the profit is unlimited) than if the same funds were invested in stocks.
One option contact corresponds to 100 shares of the underlying stocks. A trader's purchase of 10 option contracts is equivalent to investing in 1,000 shares of the underlying security. However, an option has an expiration date and a tendency to lose value over time. Therefore, an option buyer risks the loss of 100% of the premium that he paid for the option because, if the option expires, it will be worthless. At the same time, an option seller risks losing significantly more than the premium that he received when he sold the option.
An investor may choose to use options to protect a portfolio. The options can be used to protect the stocks that he owns against a sudden downward price movement.
This trading strategy is considered to be very conservative and is used in buying puts as a hedge. Basically, a trader buys a right to sell stocks that he owns at a certain price (strike price) and, in the case of a sudden drop in the stock price, he has the right to exercise the put options and sell the owned shares at a strike price or sell the owned puts and pocket a profit that may help him to keep the shares during the downswing. In the case of a Bull market, this strategy limits the profit potential by the cost of the purchased puts.
As a rule, this strategy is used when an investor believes that there is a possibility of a Bear market in the short term, but is unwilling to sell the shares he owns.
Options can be used to create additional income. This is a conservative strategy that is based on selling calls (writing covered calls) on the stock that he owns. In this case, a trader expects to receive additional profit in a flat or moderately low market when there is a strong possibility that the sold call options will expire and be worthless. Since the profit from the selling options is limited to the amount received as a premium for the options that he sells, a trader may still lose more on the owned stock in the case of a strong decline. By using this strategy, a trader who does not wish to sell stock during a Bear market, may generate some additional income.
In general, the "Portfolio Protection" and Additional Income Generation" options strategies are very similar. Both help the trader to keep his owned stock during a Bear market by generating additional income from selling calls or from the bought puts. Both of these options strategies are used when a trader expects a moderate downward correction within a major uptrend and is unwilling to sell his owned stocks. If a trader expects a strong Bear market, he is always better off by selling his owned shares, since the profit from the sold calls or bought puts may not always cover the losses on the stock portfolio.
Naked options trading is very risky - many people lose money trading them. It is recommended contacting your broker or investment professional to find out about trading risk and margin requirements before getting involved into trading uncovered options.