Mirror Mirror on the Wall, Explain for Me a Put and Call

Options are like wiccans; they frighten those who don't understand them when there is really little to fear. But even if you choose not to dabble in the occult, taking a few minutes to understand how the options market works may be a worthwhile alternative.

Options can seem like black magic, eerily predicting what's going to happen in the markets in subsequent days. In the past week or so, options activity foreshadowed a takeover of tiny Internet service provider OneMain.com (ONEM Quote) by EarthLink (ELNK Quote) and helped some savvy types see a big drop in Qualcomm (QCOM Quote) coming before the rest of the world.

Here are some basic facts about the options markets that can put you on a road to understanding a complicated but potentially lucrative market. (We'll return with more in future Options Forums.)

Calls -- Up; Puts -- Down

This basic knowledge can go a long way. A call option gives the holder the right to buy a stock at a certain price (known as a strike price) by a certain date (known as an expiration). A put gives the holder the right to sell the shares at a certain price by a certain date.

An investor who buys a call on a stock thinks the stock will appreciate enough to make up for what was paid for the option (called the premium) and make the trade a winner. In the case of a put, the investor thinks the stock will fall more than the premium paid to make that a better-than-break-even deal.

Buyers have two ways to profit. They can exercise an option and buy (if it's a call) or sell (if it's a put) the shares for a price that may be more advantageous than the current market price and quickly trade the shares for a greater profit; or they can sell the contract back at a higher price than they paid. The contract's price will appreciate with the stock price.

For example, a Cisco(CSCO Quote) July 60 put is a contract to sell 100 shares of Cisco for $60 each on or before the third Friday of the contract month, in this case July 21. It could be exercised profitably if the stock is at 55 because the holder would have paid for the right to sell the shares at 60 (the strike price), no matter what the current market price. That would lead, in this case, to a $5-a-share profit.

Even if you don't trade options, watching the market can provide hints on future stock movement. Heavy volume in calls (the amount of options contracts traded in a day is called volume) means investors expect the stock to rise between that day and the expiration date (the third Friday of the contract month). Similar action in puts means investors are expecting the stock to fall over the same time period. Sometimes the numbers can lie because of a complicated institutional trade, but if you monitor them for a week or so, you should get a pretty good read.

Sell Now, Own Later

Above, we talked about buying options contracts. Now let's talk about selling them.

You can sell an option without owning it or the underlying stock. Selling options is often a way to take in income (called "premium"), ideally without having to actually deliver or receive any shares of stock.

Unlike most assets, an options contract (typically worth 100 shares of the underlying stock) can be sold to initiate a trade. It's called being short the option.

Simply put, while an options buyer pays for a right to do something at a later date, an options seller (or writer) gets paid for taking on the obligation to fulfill the other side of that contract.

A call seller, for instance, would have to deliver 100 shares of Cisco at $60 to fulfill each Cisco July 60 call he sold, if so instructed by his broker. (It's called being assigned. Sellers are randomly matched with buyers by the Options Clearing Corp.)

Now, if he had separately bought shares of Cisco at 50 (a transaction known as a covered call), his profit is $10 on the stock plus whatever premium he got paid to sell the options contract. But there's a potential cost on the other side of the ledger. If Cisco had soared to $70, he would have lost the opportunity to make another $10 a share.

Selling options is risky because you lose, in the best case, opportunity, and in the worst case, a ton of money. A put seller, for example, is particularly vulnerable because a Cisco 60 put means the option seller, if assigned, must buy Cisco at 60 even if the market price is 55 or 50 or, yep, 40. That could lead to unlimited losses. (Strangely enough, when you are short a put -- meaning you sold one -- your position is actually a long one, meaning you profit if the stock rises or that you're willing to own the shares at the strike price.)

Any options seller wins when the option he sold expires out of the money, or worthless, and he keeps the premium unfettered by having to fulfill any obligations with the underlying stock.

An out-of-the-money call has a strike price that is higher than the current stock price; an out-of-the-money put has a strike price lower than the stock price. That makes sense because if you owned a call with a 65 strike price and the stock was trading at 60, you wouldn't want to exercise the contract to buy the shares for a higher price than you could get in the open market. In that case, the option seller is safe from being assigned.

More definitions: An at-the-money option has a strike price equal to the current market value of the stock. An in-the-money call option has a strike price lower than the current market price and an in-the-money put has a strike price higher than the current stock price.

The Price Is Right

What makes an options price? An options price (or premium) is a combination of several factors, the most important of which are intrinsic value, time and implied volatility.

Intrinsic value is the amount by which an option is in the money (out-of-the-money options have no intrinsic value). A July 60 Cisco call has 5 points of intrinsic value if the stock is trading at 65.

That option's price is likely to be higher than 5, though, because the options market prices in the ability of the stock to move in either direction (called the implied volatility) and the amount of time until expiration (called the time value). More time until the option's expiration adds risk, and the person selling you that option will want to be paid a little more for that risk. As a result, if it's June, a July option will be less expensive than a December option, and a June option will be cheaper than a July option.

Implied volatility is the trickiest to maneuver around for most investors. Implied volatility rises in expectation of news, such as an earnings report, a crucial court decision or an FDA drug approval. It also rises when a takeover becomes a possibility, so this becomes one of the key factors speculators use in the options market.

When the implied volatility of an option is high, it means the market-maker has raised prices on the options to get paid to take on the additional risk of a dramatic move in the stock. He'll do that if it's earnings season or if he sees unusual demand for a particular option.

Consider this the beginning of the first chapter of your options textbook and send any questions to [e-mail].