An option is considered a derivative security because it gets its value from something else. When you buy an option, you pay a premium to the seller of that contract. This gives you a right to buy a company's stock at a set price within a certain period of time. If the market price of the stock rises above the price set in the option, you can buy the stock for the set price and immediately sell it for a profit in the market. Moreover, if the market price falls below the set price, the owner of the option does not have to buy the stock and only loses the cost of the premium paid for that option. Options are different from trading stock in a company because investing in an option does not involve taking an ownership stake of a company.
There are two types of options: call and put, and both options can be bought or sold. Owning a call option gives you the right to buy stock. If you sell a call option, you make money on the premium, but you promise to sell the stock if the option is exercised. Owning a put option gives you the right to sell the stock at an agreed upon price. By selling a put option, you make money on the premium, but you must promise to buy the stock if the put option is exercised. This is similar to buying or short-selling a stock. You are betting that the price will rise or fall in the future.
Owning stock and owning options have their benefits. Buying options is much cheaper than buying stock. Also the risk of owning an option is much smaller because you can only lose the small premium that was paid for that option. By buying the expensive stock, you can lose much more money. Options give smaller investors the ability to invest in stock that is otherwise too expensive for them. Options also bring in a much higher percentage of return on the investment because of the smaller price of the option.
However, selling a call option can theoretically bring an infinite loss in value. For example, if you agree to sell a stock that you don't own at the price of $1 and the price keeps rising, you must buy that stock at market price as soon as the option is exercised. So if the price goes up to $100 a share, you lose $99 a share. Yet, buying stock is also risky. If you buy stock at $100 a share and the price falls to zero, you lose all your money.
It is important to note that in order to trade in options, you must have a margin account. A margin account allows the investor to trade with borrowed money. Because trading options often involve taking positions that are not covered by your own money, such as selling a call option of a stock you don't own, many investors are forced to use borrowed money to protect from losses. Trading stock can be down with a regular account. Therefore, it is much easier for the casual investor to buy stock than it is to buy options.