I once had a finance lecturer who introduced me to the Options Robot; an easy way of understanding and remembering the four basic types of financial options:
Before I explain what my lecturer was talking about, I'll first give a brief overview of each of the above types of options. Investors use options for hedging and speculating on stocks, foreign exchange, bonds, you name it.
To keep things simple, I’ll describe each type of option using stocks as the underlying asset, but you can generally apply this to most other asset types.
Long Call Options
A call is an option to buy a stock when it reaches a particular price (called the strike price). Very important in this definition is the word 'option;' the investor buying the call has the option, but not the obligation, to buy the stock at the strike price during the life of the option contract, or at the contract expiration date.
Note: Investors can usually exercise American options anytime during the life of the option contract (think 'A' for American and 'A' for 'anytime'). European options, however, can only be exercised at the contract expiration date (think 'E' for European and 'E' for expiration). I'll assume we're dealing with European options for the rest of this post, but you can just as easily apply the logic to American options.
The above diagram shows the payoff structure for a long call option. If you, the investor, are long the call, you buy the call. This means you pay for the option (but not the obligation) to buy the underlying stock at the strike price when the option contract expires.
Why would you do this? Because you're bullish on the stock; you think its price will go above the strike price before the contract expiration date. If that happens, you get to buy the stock for less than its market price.
You could then sell that stock at the market price and immediately make a profit, or you could hold the stock for longer if you think there's more upside. As the diagram shows, the higher the stock price goes above the strike price, the more profit you make.
You probably noticed the dotted line showing the premium for the call on the above diagram. You need to pay the premium to obtain the right to buy the stock at the strike price.
If at the expiration date the stock price is below the strike price, it wouldn't make sense to exercise your right to buy the stock at the higher strike price. In this case, your loss on the call would be equal to the premium you paid upfront to buy the call.
You would only profit from the long call if, at the contract expiration, the stock price is above the strike price by more than the premium you paid upfront.
Note: Your maximum loss on a long call is limited to what you paid on the premium. Your maximum gain on a long call is unlimited since the stock price can in theory go up to infinity.
Short Call Options
For every call buyer there must be a call seller. If you sell a call, you're short the call and bearish on the stock; you think the stock price will fall below the strike price before the contract expires.
The above diagram shows the payoff structure of a short call as the mirror image of a long call.
With a short call, you receive a premium up front as compensation for having the obligation (rather than the option) to sell the stock if the stock rises above the strike price.
If the stock price is below the strike price at expiration, the long call investor won't exercise his or her right to buy the stock, so you won't have to sell the stock for less than it's worth. If that happens, your profit is equal to the call premium you receive upfront.
As the stock price goes up above the strike price, your profit on the short call goes down. After the price reaches the break even price, your premium no longer covers your losses so you lose money.
Note: The payoffs for a short call are opposite to those of a long call. Your maximum gain is capped at the value of the premium, your maximum loss is unlimited because in theory the stock price can rise to infinity.
Long Put Options
A put is an option to sell a stock at the Strike Price. If you're long the put, you pay a premium for the option (but not the obligation) to sell the stock at the strike price.
Why would you do this? Because you're bearish on the stock. You think the stock price will be below the strike price at the contract expiration date.
If the stock price goes down, you can sell it at the higher strike price. The lower the stock price goes, the more you profit. The image below shows how this works...
If the stock price goes up above the strike price, you wouldn't cash in your option to sell the stock at the strike price - you would be better off selling the stock at the stock market price. In this case, your loss would equal the amount you paid for the premium.
Note: the amount you paid for the premium upfront is your maximum possible loss on a long put. Since zero is the lowest possible stock price, your maximum gain on a long put is equal to the strike price minus the amount you paid for the upfront premium.
Short Put Options
Just like with call options, you can sell put options and receive a premium. If you're short the put, you think the stock price will be higher than the strike price at the option expiration date. You have the obligation (rather than the option) to buy the stock at the strike price if it is higher than the market price when the contract expires. In other words, you lose out the more the stock price goes down.
As shown above, the maximum profit you can earn on a short put is the premium you received upfront when you sold the put. Since the stock price can only decrease to zero, your maximum loss is equal to the strike price minus the premium you paid up front.
Put-Call summary table
Putting it all together with the "Options Robot"
You'll have to excuse my artwork here, but I hope the above picture resembles a Robot. If you're ever stuck on which payoff structure goes with which option, this picture will hopefully help you remember. I've excluded the effect of the premium to keep things simple, and to stop the illustration from looking too strange.