What are Options?

An option is a derivative financial trading product that gives an investor the right, but not the obligation, to buy or sell a stock at an agreed upon price and date. Call options and put options form the basis for a wide range of trading strategies designed for hedging, income, or speculation.

Options Versus Stocks

Options are a way for you to have a financial interest in the stocks that you are interested in without actually owning shares of the stock.

There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise.

Call Options

Owners of call options expect the stock to increase in value, while sellers of call options expect the stock to decrease in value or remain the same.

Buying a call option contract gives you the right, but not the obligation, to buy 100 shares of the underlying stock at the designated strike price. The value of a call option appreciates as the value of the underlying stock increases.

Selling a call option allows you to collect the premium while obligating you to sell 100 shares of the underlying stock to the owner at the agreed-upon strike price.

What if you think the price of the stock will increase in value?

In this case you'd buy to open a call position. Buying a call gives you the right to purchase the underlying stock from the option seller for the agreed-upon strike price. From there, you can sell the stock back into the market at their current market value if you so choose.

For example, you think XYZ's upcoming product release is going to send the price of the stock soaring, you could buy a call option in XYZ at a $10.00 strike price with a $1.00 premium (the cost of the contract) expiring in a month.

Let's break that down.

Symbol: XYZ
Expiration: A month from now
Strike Price: $10.00
Premium: $1.00

The product release gave the stock a bump, and the day your contract expires, XYZ hits $15.00 a share. Great! This means you can sell the contract in the market for $5.00 and earn a profit of $4.00 per share.

Put Options

Owners of put options expect the stock to decrease in value, while sellers of put options expect the stock to increase in value or remain the same.

Buying a put option contract gives you the right, but not the obligation, to sell 100 shares of the underlying stock at the designated strike price. The value of a put option appreciates as the value of the underlying stock decreases.

Selling a put option allows you to collect the premium, while obligating you to purchase 100 shares of the underlying stock from the owner at the agreed-upon strike price.

What if you think the price of the stock is going down?

In this case, you could buy to open a put option. Buying a put gives you the right to sell the underlying stock back to the option seller for the agreed-upon strike price if you so choose.

For example, you think XYZ's upcoming earnings call is going to tank the price of the stock, so you buy 1 XYZ put option expiring in a week with a strike price of $10.00 for a premium (the cost of the contract) of $2.00.

Let’s break that down.

Symbol: XYZ
Expiration: A week from now
Strike Price: $10.00
Premium: $2.00

Your prediction is right, and within a week XYZ is trading at $6.00. Your put option is now worth $4.00, so you can sell it in the market for a profit (less the cost of your $2.00 premium). You’ve just made a profit of $200.00 on XYZ’s decrease in value.