Rights & Obligations
Just mentioning the word "option" has me immediately hearing "right, but not obligation" in my head. It was drummed in incessantly every time any lecturer started talking about them. Because a thorough understanding of who has the "right" and "obligation" is important for understanding the motivations of parties in a transaction, but also in understanding how exposed you are to risk. And trading of all sorts, much like poker, is largely a game of managing risk.
A person who buys an option is purchasing the right to either buy or sell some stock, at a pre-determined price, at a pre-determined date in the future. They don't have to do anything though, taking any future action is completely optional, hence the name. As we'll see later though, it's easy to determine what action that person will take based on the price of the stock. We're all rational actors in this market, and if taking up that offer to buy or sell shares would make a quick buck the person will definitely do it. Taking action on the option you've purchased is referred to as "exercising the option".
As a buyer of an option you have bought "the right, but not the obligation" to buy or sell stock in the future. The maximum amount of money you can lose is whatever your initial outlay was to buy the option, you've made no further promises.
In every contract there is at least two parties. If someone is buying an option then someone must be selling it to them. The seller of the option has now agreed to either purchase some stock or sell some stock, at a pre-determined price, at a pre-determined date. It can seem like a subtle distinction, but it has significant consequences. Somebody has given you money to have the right to make you buy or sell some stock in the future. If they decide to exercise that right, you need to hold up your side of the agreement. Again we're all rational actors here, so if you've agreed to buy XYZ for $14.00 and XYZ is currently trading at $15.00 the option isn't going to be exercised. Whoever purchased the option could make an extra $1.00 by just selling their stock the regular way on the market.
But what if you'd agreed to buy it for $5.00? You've now paid $10.00 more than you had to :( Options work in both directions though, the other party may have paid to have the right to buy stock at a pre-determined price. If they'd bought an option to buy your stock for $3.00, you'd now have to sell them what you owned for $12.00 less than you could have sold it elsewhere. What if you didn't actually own any of the stock? You'd now have to go buy some for $15.00 only to turn around and immediately sell it for $3.00. Ouch!
What if the stock was trading at $25.00? $50.00? $100.00? The latter would have you make a loss of $97.00 per share. Depending on the way your trade is structured, your maximum theoretical loss from selling an option is unlimited. Be safe out there kids!
But why would you do that?
It all comes down to understanding sentiment and motivation. One of my favorite all-time hacks of the financial system can give an example of these principles, and gives great insight into the prevailing sentiment that drove the decisions of the parties involved. From there we can explore the basic implementation of these with covered calls and covered puts.