In the bluntest terms, option contracts are limited term up (calls) or down (puts) bets that are 100:1 (for stocks) leveraged that traders and speculators can buy and sell.
Each contract is worth 100 shares of that particular stock, with the option to buy or sell the stock at the strike price. The strike price is the over/under price that determines whether or not the option contract will have value by its expiration date: usually, the third Friday in a designated month.
Example:
Facebook (NASDAQ: FB) is trading at 150 In October. If one thinks FB will reach 160 by mid January, she could buy 100 shares of FB at a cost of $15,000. That might be a bit out of budget for some investors to allocate for a single stock, and a 10-point gain would yield a profit of $1,000 before commissions, or 6%. On the other hand, a single call option contract of FB January 150 might be at 5, or cost $500. If FB did indeed go to 160 before or by mid-January, the call option would be "in-the-money," i.e. over the strike price of 150 for 10. As long as the contract was either sold (realizing a 100% profit before fees) or exercised (purchasing the stock for 150 when the current price is now 160, thereby locking in the profit).
On the plus side, option contracts are very leveraged, but the cash outlay is small enough to manage for a singular speculation without risking a significant part of a portfolio budget, and can multiply one's profit if a number of contracts are obtained and the bet is correct. On the negative side, the risk is high, since the premium value erodes with each calendar day. Stagnancy or a trend against your bet's direction can result, and often does, in loss of the entire trade amount, if not carefully monitored.
Option contracts are considered derivatives, and are also the mechanical basis for all other kinds of derivatives trading, most notably in futures. The futures market includes options, indexes, interest rate securities swaps, commodities, foreign exchange, warrants, and even more obscure markets, such as carbon credits, tax credits related to film and TV production, and others.
Related or Semi-related Video
Finance: What Is a Put Option?83 Views
finance a la shmoop what is a put option? hot potato hot potato
ow ow! yeah remember that game well nobody wanted the potato, poor thing. the
players wanted to put it in someone else's hands. well put options kind [glue put around a flaming potato]
of work the same way. a put option is the right or option or choice to sell a
stock or a bond at a given price to someone by a certain end date.
all right example time. you bought netflix stock at the IPO a zillion years
ago at $1 a share. that's you know splits adjusted. all right now it's a hundred
bucks a share. if you sell it you pay taxes on a gain of 99 dollars a share. in
California that would be a tax of something like almost 40 bucks. well the
stock was a hundred but you keep only something like 60. feels totally unfair.
right so you really don't want to sell your stock but you're nervous about the [graph shown]
next few months that Netflix will crater for a while and go down ten
maybe twenty dollars. longer term though you think it'll hit 300. so this is the
perfect setup to maybe look at buying some put options on Netflix. if the stock
goes down your put options go up. with Netflix volatile but at a hundred bucks
a share ,you look up the price of an $80 strike price put option expiring in
December, and you know that's mid-september now .for five bucks a share
you can protect your stock for the next few months .think about it like temporary [stocks placed in vault]
term life insurance. you pay the five dollars a share in the stock goes down
to 82 by mid December, worst of all worlds. well not only did you lose the $5
a share but your stock has lost $18 in value. but had Netflix really cratered
and gone to say $60 a share well you would have exercised your put and sold
your shares at 80 bucks. well those put options you paid $5 for
would be been worth 15 bucks a share. in buying that put option you've [equation shown]
guaranteed that your loss will be no more than a $75 value for your Netflix
position at least for that time period and ignoring taxes. well remember that
options expire after December whatever like the third Friday of the month it's
usually when options expire, you then have no protection and your shares float
along naked. naked? really who knew accounting could get so [paper put option goes "skinny dipping".]
raunchy. yeah well that's naked put options.
that's what they really are people.
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