Posted August 1, 2023

Just like stock traders, option traders hope to make money by buying the option at one price and selling the option at a higher price.

In the case of a stock the trader buys a stock, and they can hold the stock for fifty years. There is no obligation to sell it. Ever. The buyer is the trader, and the seller could be the company itself or more commonly another trader. For the trader that likes to live dangerously they may sell the stock short. The objective of this strategy is to sell stock high and buy low. And in that order. The short seller borrows stock shares (at a fee) from their broker, then sells them to a buyer on the market. By doing this the trader creates a “short” position, and then hopes to buy the shares back at a lower price. There is a rub. Whereas the stock buyer can lose at most 100% of the purchase price of the stock, the short seller is exposed theoretically to unlimited losses. If the short seller borrows shares 10,000 and sells them at $10, and but two minutes later the company announces that it has discovered the cure for all cancers, the short seller will get crushed as the stock skyrockets to $1,000 a share in an hour and keeps climbing. To escape the predicament, the short seller must immediately buy the shares back at $1,000 each, netting a loss of $990 on each of 10,000 shares. Ouch.

There are a few important differences for options trading. First, there are two types of options that may be purchased, calls, and puts. Secondly, the trader may take either side of the transaction. The trader may buy the option and enjoy the rights, or the trader may be the seller of the option, and, in exchange for a premium, accept the obligation to fulfill the contract should the buyer exercise their rights. With options trade it is a zero sum game. The dollar that the buyer gains comes from the account of the seller, and vice versa. The other important difference in options trading is that one can buy a put and benefit from a price drop in the stock price, without the risk of shorting a stock.

So, with options trading who wins, and how?

The call buyer wins if the stock’s price increases above the strike price. The increase in value of the option must cover the premium paid, so the call buyer needs a strong surge in the stock price, and that must occur by expiration. The call buyer could then exercise their right and purchase the shares from the call seller at a discount to market value, and immediately sell the stock on the market for a quick profit. Alternatively, the call buyer could sell the call at any point before expiration and pocket the profit.

The put buyer wins if the stock price falls below the strike price. The put buyer could then put the shares to the put seller above the market price. One could buy a put to protect shares of stock, as a put gives the option to the stockholder to sell the shares at the strike price, even if the stock price were to drop to zero. The put seller must honor the obligation and buy the shares at the strike price. One could think of a put as an insurance policy in case a stock’s value plummets. As was the case with the call, the put seller could also sell the option and pocket the profit.

The call seller wins if they keep the premium without being assigned to fulfill the obligation. Although the call seller may be assigned at any time for any reason, it only makes financial sense for the call buyer to exercise the call option if the stock price rises above the strike price. It would produce a loss for the call buyer to exercise and purchase stock for more than market price.

The put seller has three beneficial outcomes and one bad one. The put seller wins if the stock price rises, remains unchanged, or drops slightly. The put seller loses if the stock price drops sharply as they would be obliged to purchase the underlying stock at well below market value for a short-term loss. The bright side in that scenario is that the stock price could rebound and cover the loss, or perhaps even turn a profit, eventually.