The concepts of stock options and option trading often strike the average investor as being vague and mysterious. In truth, most of us are primarily familiar with the stock market as a place to buy and sell shares of publicly traded companies. (A share represents a unit of ownership in the company.) However, there are other financial instruments that are also traded daily. Options are one such instrument.
In general business terms, an option usually represents the right to purchase some item at a specific price. For instance, you may be interested in buying a rental property for $100,000 but aren’t sure whether it’s a good deal. In such circumstances, you may be able to give the seller some amount of money - say, $1000 - to take the property off the market while you make up your mind. In other words, you pay $1000 for the option of buying the property. (Basically, you’re not obligated to make the purchase; you have the option of walking away from the deal.) Regardless of whether or not you decide to buy, the seller keeps the option money. Stock options operate in a similar fashion.
With respect to the stock market, an option is a right to buy or sell a particular stock at a certain price (known as the "strike price") within a particular time period. An option that represents a right to buy is known as a "call"; an option representing a right to sell is known as a "put." Unlike stocks, which you can buy and hold forever, options will always have expiration dates - usually the third Friday of a particular month - meaning that an option buyer has a finite amount of time in which to profit from his option trade. In addition, options are only sold in units called contracts, with each contract representing 100 shares of stock. Finally, options have their own price, which is separate from the price of the underlying stock. Here’s an example to show how an option trade might work:
Assume the stock of Coca-Cola is at $63 in October. One could purchase a call on this stock, offering to buy it at a strike price of $65, with the call expiring in December. In other words, the option buyer in this scenario would have the right to buy Coca-Cola stock at the price of $65 per share any time between now and December (or more specifically, the third Friday in December). If the price of the December call is $1 (remember, the option price is not the same as the stock price), the buyer could purchase one contract – representing 100 shares of stock – for $100. (The call price is the price for each individual share of stock represented by the contract. Ergo, one contract would cost $100, 3 contracts would cost $300, and so on.) If the buyer decides to purchase the stock, he will "exercise" the option. However, the buyer can also, if he chooses, simply sell the option on the open market.
This, in general, is how stock options are traded. We will discuss various ways to make money trading options in the follow-ups to this article. However, no one should be under any illusions when it comes to investing via options: while the rewards of option trading can be substantial, you can indeed lose your entire investment and have absolutely nothing to show for it. Simply put, trading options is not for the faint of heart.