Trading stock options is a way to get into stock investing without huge amounts of money while at the same time limiting your risk of losing money. Trading options has its own vocabulary and procedures. While much of it may be counterintuitive, there are similarities between stock options and buying insurance to protect an asset, such as your car.
Understanding the Options Vocabulary
An option represents a choice an investor has when dealing with stocks, equities, exchange traded funds and other similar products. The option itself is a contract for 100 shares with a predetermined price, called the strike price, and an expiration date. There are two basic types of options, referred to as calls and puts, synonymous with buying and selling. An easy way to remember these is to think of buying as "calling in" and selling as "putting out." The buyer of an option purchases the right to buy or sell 100 shares at the strike price, for a premium. The seller, called the writer in options terms, is obligated to sell or buy if the buyer exercises the option.
How Options Limit Risk
The buyer of an option has the right, but not the obligation, to buy or sell under terms of the option contract. Consider car insurance for a moment. You purchase insurance for a fraction of the cash value of your car, in case you have an accident and have to repair or replace your car. Your insurance premium gives you assurance that you are not risking the total value of your car. Purchasing an option contract is similar. The buyer predicts a stock will gain or lose value by a future date, and purchases an option where the strike price is lower or higher than the stock's predicted value. If the buyer is wrong, he lets the option expire, forfeiting only the stock option premium -- not the loss of value for those 100 shares.
Making Money With Call Options
When the value of a stock rises above the strike price of a call option before it expires, the buyer could exercise the option and purchase the shares. However, now the option has a value of its own, and this is typically how options trading makes money. The buyer may now sell his contract to someone who wants to purchase that stock cheaper than the current market rate, which the option writer is obligated to provide. The value of that sale depends on the difference between strike price and current value, and the time remaining on the option. As long as the buyer recoups the option premium, a profit is realized.
Making Money With Put Options
The buyer of a put option wants the value of a stock to fall below the strike price. In this case, the writer is obligated to buy 100 shares at the buyer's option for a price which is now higher than the market. That option contract becomes attractive to holders of the falling stock. The buyer earns a profit by selling the put option for an amount exceeding the option premium.