Options have two variations regarding the way they can be exercised. The European option can be exercised only at the expiration date. The American option can be exercised at any time prior to expiry.
Regarding the rights they give for the underlying asset, there are two types of options – call and put.
CALL OPTIONS
Buying Call Options
A call option gives the investor the right (without the obligation) to buy an asset, at a strike price, until a certain date. It is an agreement that the buyer of the option makes with the seller of the option, and for that the buyer pays the seller the premium (the price of the option).
If you’re buying a call option, it means that you are expecting the price of the underlying asset to rise. If the option becomes profitable, you can exercise it and buy the asset at the strike price. That means you’ll now own the asset at a price, lower than the current market price. You can sell immediately and take your profit.
If the call option doesn’t become profitable, you would not exercise it and it would simply become worthless at the expiration date. Your loss would be the premium paid to the seller of the option.
Selling Call Options
The other way to exit a call option is to sell the contract itself. This is called writing a contract and the seller is called writer.
If the price drops and the option is not exercised by the buyer, your profit (as a writer) would be the price you received from the sell. You can even profit from the remaining time value of the contract, if there is any left.
Things look a bit different for the writer in case the current price is above the strike price. If a buyer decides to exercise the option, the writer could be assigned the obligation to deliver the terms of the options contract.
In that case, you would have to sell the underlying asset (say shares) to the buyer at the strike price. If you have those shares in your portfolio holdings, you can sell them to him (at an unfavorable price, as the strike price is lower than the current).
If you don’t have them, you must buy from the market (at the current higher price) and sell them to the buyer (at the strike price). Both mean that you would incur a loss.
The bright side of it is you do receive the premium. Also, there is a good chance that you won’t be assigned. This is a random process and the average probability for assignment is about 17 %.
PUT OPTIONS
Buying Put Options
The put option is a contract that gives the investor the right (without the obligation) to sell the underlying asset, at a strike price, until a certain date. You buy a contract that gives you the option to sell the underlying asset. For that you pay the premium (the price of the option).
When you’re buying a put option, you are expecting the price of the underlying asset to drop. If the market price falls below the strike price, you can exercise it and sell the underlying asset for a profit.
If the price instead rises, you could let the option expire, without exercising it. At expiration date it would be worth zero and your loss would be the premium paid.
Selling Put Options
A holder of a put option may decide to sell it if he believes the price of the underlying asset will stay the same or increase.
If the market price stays around the strike price or increases, the odds are buyers will not exercise their right (because they don’t want to sell the underlying asset at the lower strike price) and will let the option expire worthless. The profit for the seller is the received premium.
However, if the current price of the underlying asset drops below the strike price, buyers might choose to exercise their put option by selling the asset (e.g. shares). The writer may be assigned the obligation to deliver the terms of the options contract and to buy the underlying asset at the higher (than the current market) strike price.
The put writer can either hold the shares and hope the stock price would rise back above the purchase price or he can sell them immediately and take the loss.
Of course, the bright side – he does receive the premium. Besides, there is a good chance that he won’t be assigned. This is a random process and the average probability for assignment is about 17 %.
The bottom line here is that an investor needs to enter into a contract with a clear view of the parameters of the trade and the possible exits.
Neither buying, nor selling a contract is a bad thing, you just need to be prepared.
