Gabe Fransen | April 19, 2024

If you’re new to the options game, you might feel overwhelmed by the jargon and complex strategies. We wanted to break down the basics of two fundamental options contracts to help educate you in this area: puts and calls. By the end of this article, we want you to have a solid understanding of how these financial instruments work.

First, let’s answer the basic question: What are Options? Options are financial contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price (the strike price) within a specific time frame (expiration date).

Call Options gives the holder the right to buy the underlying asset at the strike price. You are essentially “locking-in” a future purchase price for a period of time. Investors typically buy call options when they believe the price of the underlying asset will rise. If the asset’s market price increases above the strike price, the call option becomes more valuable, allowing the holder to either exercise the option and buy the asset at a discount or sell the option at a profit. An example of this would be: You buy a call option on ABC stock with a strike price of $100, and the current market price is $90. If the price of XYZ stock rises to $105, you can exercise the option and buy the stock for $100, making a profit of $5 per share ($105 – $100). Alternatively, you can sell the option contract for a profit without actually buying the stock.

Put Options, on the other hand, gives the holder the right to sell the underlying asset at the strike price. You are essentially “locking-in” a future selling price for a period of time. Investors typically buy put options when they believe the price of the underlying asset will fall. If the asset’s market price decreases below the strike price, the put option becomes more valuable, allowing the holder to either exercise the option and sell the asset at a premium or sell the option at a profit. An example of this would be: You buy a put option on XYZ stock with a strike price of $100, and the current market price is $105. If the price of XYZ stock falls to $95, you can exercise the option and sell the stock for $100, making a profit of $5 per share ($100 – $95). Alternatively, you can sell the option contract for a profit without actually selling the stock. Put options can be used as a hedge for investments that you already own. You hope the investments that you own will increase in value, but if it loses money instead, you can sell it for the strike price specified in the option.

The benefit of utilizing options as explained above is hopefully understood. So, one would ask, “What’s the risk that is associated with those benefits?” The primary risk is that the market price of the underlying asset may not move in the direction you anticipated, causing the option to expire worthless. Additionally, options have an expiration date, which means time decay can erode the value of the option over time.

The cost of options, including puts and calls, varies based on several factors such as the underlying asset’s price, the strike price, the time to expiration, and the volatility of the underlying asset. Each options contract represents 100 shares, and the cost is determined by the premium paid for the contract. For example, if the premium for an options contract is $500, it would cost you $500 to purchase one put or call contract. This premium is the price you pay for the right, but not the obligation, to buy or sell the underlying asset at the specified strike price before the expiration date. It’s also worth noting that the cost of an options contract can be influenced by supply and demand in the market. If there is high demand for a particular options contract, the premium might increase, making it more expensive to buy or sell that contract. Conversely, if there is low demand, the premium might decrease, making it less expensive.

Through Royal Fund Management, we offer three different strategies that utilize options. Each of these strategies are designed for different objectives and risk tolerances and we’d enjoy the opportunity to share additional information and insight regarding these strategies and how they may fit into a portfolio.