The confusing stock option

Ok, I like this one. There are two types of stock options: call option and put option. Call option is also called buy option and put option is also called sell option.

Buy option is a privilege, sold by one party to another, that gives the buyer the right, but not the obligation, to buy (call) a stock at an agreed-upon price within a certain period or on a specific date.

Sell option is a privilege, sold by one party to another, that gives the seller the right, but not the obligation, to sell (put) a stock at an agreed-upon price within a certain period or on a specific date.

Here is the example I used to understand them.

Alice recently got promoted  and she’s buying a new car. So she put her old car for sale. Bob sees the car and likes it. But the dealer where Alice buys her new car doesn’t have the color she chooses so she has to wait for 4 weeks.

When they sit down and negotiate, they agree upon the sale price for $10,000 and Bob can have the car in 4 weeks, and Bob need to pay a 5% deposit ($500). That’s what we are actually doing in our real life, right?.  What does Bob get for the $500 deposit? He gets the right to buy Alice’s car for $10,000 in 4 weeks. What if Bob changes his mind not to buy the car for whatever reason? (He may find a similar car for $9000, for example) Fine, but he loses the $500 deposit. What if the market value of Alice’s car go up to $11,000? Since Bob pays the deposit, he will still get the car for $10,000. He’s happy and if he sell it he can make a profit of $1000. This is a buy option for the buyer (Bob).

Now Let’s think about the story in the other way. This time Alice agree to pay a 5% deposit to Bob. (You never see this happening in real life, right?) What does she get from the deposit? She gets the right to sell the car to Bob for $10,000 in 4 weeks. What if Alice changes her mind not to sell the car to Bob for whatever reasons, for example,she finds out she can sell her car for $11,000? Now she loses $500 deposit. But she may sell it for $11,000. What if the market value goes down to $9000? She can still sell her car for $10,000. And you bet she’s happy for that. This is a sell option for the seller (Alice)

Both of the two scenarios are valid in stock market and are used in different ways. Buy option is usually used when an investor predicted a certain stock’s price is going to go up in a certain period of time, but wants to limit risk. (the worst situation is that he loses the money he spends on option (the deposit)) And sell option is usually used when a investor wants to lock down a profit on his stock in case future price goes down.

Stock option is a good tool for experienced investors.