What Option Contracts are and Why People Use Them
If I buy some shares of stock and the price goes up, I will make money, and if it goes down I will lose money. Option contracts allow people to use more sophisticated strategies than is possible with stock. Instead of depending purely on a price move you can make money by having the stock stay within a certain range during a certain time. You can also profit on changes in volatility of a stock using options.
Options allow many complicated strategies but when you boil it all down there are only two types of options: calls, and puts. People who have money in stocks sometimes have the fear of a stock market crash or a bankruptcy. People can buy insurance that would protect their stock in the case of a large drop in price. This insurance is called a put option. Put options allow you to sell your stock at a certain price during a certain time. Let’s say you have 100 shares of a stock worth $20 per share, you could buy a put option that would allow you to sell your shares at $17 per share for the next month. In this case the $17 is what is known as the “strike price.” If the shares were to drop to zero in the next month then you could sell your worthless shares for $17 each. Put options are used like this to protect investments.
Call options are used more as a tool for speculation since it has the possibility of making a large gain for little money up front. The strike price for a call option is the price at which the owner of the option can buy stock. If you saw a stock that you might want to buy at $20 per share but only because of the possibility of a large increase in a short time, you might buy a call option instead of the stock. You could buy a call option with the strike price at $21 that is good for the next month. If the stock went up to $30 per share within a month then you could buy that much more valuable stock for the strike price. In this case you could have participated in this gain for the cost of the call option instead of the $2,000 it would have taken to buy 100 shares at $20.
Along with buying options you can also “short” option contracts. Shorting is where you sell something you do not own. In the case of shorting stock you have to borrow the shares and then buy them back later. In the case of options you do not need to borrow anything since it is a contract that does not exist until you along with the other party decide it exists. Since options expire at some point they will go down in value as the time to expiration gets closer assuming no price change. It can be smart to buy back option contracts at some point after time-decay has taken a chunk out of the value of the option. However you never have to buy back your short option positions unlike short stock positions if the options expire worthless.