The two types of options are calls and puts.

A call option gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of call options are expecting that the stock price will increase substantially before the option expires.

A put option gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of put options are expecting that the price of the stock will fall before the option expires.

Buyers and Sellers in the Options Market

There are four types of participants in options markets depending on the position they take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

If you buy an option you are called the holder of the option and if you sell an option you are called the option writer.

If you are the buyers are said to have a long position, and if you are the seller you are said to have a short position.

There are important distinctions between option buyers and option sellers which affect the risk associated with the option contract. Here is a summary of those distinctions.

• Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights or let the contract expire without exercising their right.
• Call writers and put writers (sellers), however, are obligated to buy or sell if the holder exercises their option. This means that a seller may be required to make good on a promise to buy or sell.

If this seems confusing at first, it becomes more clear as you get into some concrete examples, which we do on other articles here.

Also, you need to understand that an option buyer has a known and manageable risk (the cost of the option contract plus brokerage commission is the entire risk). The potential gain by an option buyer is theoretically unlimited, but will always have some discreet value when the option is exercised.

Consider this simplistic example: You buy a call option on stock XYZ. As the holder of the option, you have the right to  buy 100 shares of XYZ stock on or before a set future date at $10 a share. At the time you buy the option, the XYZ stock is trading at $7 a share, so the writer is betting that the stock won’t go up by $3+ dollars by expiration. But let’s say the stock goes bonkers and climbs to $100 a share by expiration. You exercise your right and get to buy 100 shares of XYZ from the writer for $10 a share.

Where does that stock come from?

Well, the writer either has the stock in his portfolio (he wrote a covered call) or he doesn’t (he wrote a naked call). Either way he loses. If he owns the stock, he’s obligated to sell the stock that is worth $100 a share to you for $10 a share – so he loses out. If he had bought the stock earlier at a sub $10 price, he didn’t lose money on the stock , but since he could have otherwise sold it for $100, he lost out on the ability to cash in on that profit.

On the other hand, if the writer wrote a naked call, he could be in some serious cash-flow problems. You see, he now has to go out and buy the shares at market price ($100 per share, or $10,000 for one contract) and then turn around and sell those shares to you for $10 per share. In this case the writer is out a very real $9,000. Ouch.

So the potential risk of an option writer much higher than an option buyer.

You may be asking yourself at this point, “So why would anyone ever want to write options if it is so risky?”  Well, if you know what you are doing, you can make a lot of money by pricing your contracts in such a way that you have the advantage. The key phrase is that you have to know what you are doing, and you need to know it really well.

For this reason, option writing is a much more advanced and strategic topic, and it’s best to wait until you are an advanced options trading before you begin trading options as a seller. So if you are a beginning options trader, stick with buying options until you have more experience.

In fact, some very successful options investors are content to use managed strategies that never delve into options writing. But if you get really good at trading options, you may want to try your hand at writing options at some point. At this point, it is good enough to just understand that there are always two sides of an options contract.