If you’re like a lot of investors you have tried once or twice to have options explained to you properly, but for one reason or another had a difficult time really understanding even stock options basics. You should know that virtually everyone had to make an effort to really “get” options in the beginning, but I can assure you that understanding them is not beyond you. I have had to explain them professionally, and I found that by explaining both sides of an options trade people often have an easier time understanding the concepts.

By “both sides of the trade” I do not mean puts and calls. I mean the transaction in which the option buyer and seller of a call option OR a put option are involved. I’ll illustrate the mechanics with calls, as a simultaneous put options explanation might be confusing.

Let’s say you own 100 shares of XYZ stock, and it’s currently trading at $100 per share. After a recent run-up you fear that the price may drop back but you still feel good about the fortunes of the company and stock for the long-term, so you don’t want to sell. You could sell an option contract to purchase your 100 shares but let’s say $110 per share. The stock option contract has an expiration date, in this case let’s say it’s two months away from right now.

Let’s say that two months from now the stock is trading at $120 per share. Having sold the “XYZ 110 call option”, you are obligated to deliver your 100 shares to the buyer of the option for $110 per share. The option is “in the money” so the option buyer is very happy, as after buying the 100 shares at 110 for $11,000 he could immediately sell the shares for $12,000. The only money he put up to enable him do this was the premium amount he paid you when he bought the stock option from you. Remember, he did not initially buy the stock from you. He bought the right buy the stock at a certain price by a certain date from you.

So what’s the difference? Well, what if by the expiration date the stock was trading under 110? At that point the right to purchase shares at 110 would be worthless because no one would ever buy shares at a higher price than where there are currently trading in the market. The right that he bought, i.e. the option, would expire worthless for this reason and he would lose all of the premium amount they pay you for the option. As you keep this premium, your cost basis for owning the stock is lowered slightly, which means that selling the option functioned as insurance before you. Remember that you have decided to keep the stock when it was trading at 100, so if it goes to 90 or 80 by expiration you are not happy but you are slightly better off than if you had not sold the option.

On the other hand if the stock is at 120 two months from now, you still benefit from the run up between 100 and $110 per share. You also still keep the premium amount that the option buyer paid you. You simply do not benefit from the move between 110 $120 per share, the buyer does.

You can see that by selling the option you received some small amount of insurance in case the price of the stock moved against you. The option buyer risked a relatively small amount of money in the hope that a relatively large move in the stock price would result in him making multiples of his original investment.

In this way it should be clear to you that the motivations of the option buyer and seller are diametrically opposed. The option buyer purchases a leveraged position with a relatively small amount of money in the hope of making a large percentage gain. The option seller buys a little bit of protection at little or no risk to his stock position, outside of the opportunity cost of getting his shares called away from him in the event that the stock price really rockets upward.

I hope you understood this short explanation. Even if you did however, you should paper trade options before you actually use real money to trade them, either on the buy or sell side. Options are unpredictable and extremely volatile, and there’s a big difference between understanding the concepts and applying them successfully in the markets.

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