A stock option is a contract between the seller and the buyer of the option which gives the buyer the right to purchase or sell the stated amount of shares in the future at an agreed upon price. The buyer of the option is not required to exercise his right to purchase or sell the actual shares from the seller of the contract. If there is no advantage to exercising it the contract will normally expire worthless.
What does this look like in the real world? All option contracts bought and sold through brokerages are for 100 share lots, and are sold at various price increments (known as strike prices) depending on the underlying symbol. The contracts being sold expire at various time periods in the future, which are standardized and normally fall on the third Friday of the contract month. A buyer may buy either put or call options, and the distinction is very important. A trader can see the full list of options contracts available to trade on what is known as an options tree.
A call option gives the buyer the right to purchase shares of stock in the future at the designated price. A buyer will purchase a call option contract when he believes the price of the stock will increase to more than the strike price plus the cost of the option. If the price increases, the value of the contract is likely to go up with it. If the stock at the end of the expiration date has a higher price than the option price, the owner can then purchase the stock for the option price and if he wishes immediately sell those shares in the open market at a higher value.
A put option gives the buyer of the option the right to sell a stock security at an agreed upon price in the future. A buyer of a put option believes that the price of a stock will fall below the strike price of the option plus the cost paid. If on the expiration date of the option the stock is trading at a lower price than the exercise price, the owner may purchase shares from the open market at the lower price and then sell them for the agreed upon option price to the seller of the contract, and will profit the difference (minus the original cost paid).
Option contracts give traders a way to increase their profits in a trade over simply buying or shorting shares on the open market. How do options do this?
As an example let us say that a particular stock is trading at $48. The trader believes that by the option expiration date, the stock will be trading at $52. Currently $50 call options are being traded at .50 per share, or $50 for the contract. If a trader buys the contract today for $50, and he is right and the stock goes to $52 at expiration, he has now made the $1.50 difference $52 market value – $50 strike price -.50 cost paid. So the $1.50 multiplied by the 100 shares in the contract means the trader has profited $150 on his $50 investment, a return of 300%!
If the trader invested the same $50, well $48 dollars, to buy the stock on the open market, he could have bought 1 share, and his profit would have been $4, a return of 8.3%. The same investment in an option in this example resulted in a profit of $146 more!
The caveat to this is that option contracts do not necessarily end up being worth any money. If the price on the expiration date was $50 or less, the contract would be worthless and the trader would lose 100% of his investment in the option.
Because there is a potential to lose 100% of your investment (investment used loosely as options are used more for short term trading) brokerages typically will require the trader to be sophisticated enough to understand how the contracts work before they will give you privileges to actually trade them. There are also varying degrees of option privileges as more sophisticated traders are also allowed to sell option contracts, which can expose the trader to enormous amounts of risk.
I should also mention that options are used by sophisticated investors as a way to hedge risk. If they are long a position they may also purchase put options to provide protection should the price fall dramatically, as the put options will increase in value to offset the decline on the principal investment. Call options can also similarly be used as hedges.
There are many options trading and hedging strategies, which can become very complex. The most important factor for a trader new to options to understand is that they increase leverage, which magnifies gains and potentially losses. It is crucial that the trader understands how the option he purchases will change in price in various scenarios, both upon expiration and before.