An option is the right to buy or sell something at a specified price within a certain amount of time (typically a few months). In the financial world, there are options on stocks, indexes, interest rates and futures contracts.
Say you believe a certain stock is about to skyrocket. Instead of buying it at $6 a share with the hunch it is about to hit $12 a share - which would double your money - you find on an exchange an option to buy the stock for $10 a share. The going rate for the option is 12 1/2 cents a share. Stock options are usually sold in lots of 100 shares, so the price you pay - the non-refundable premium - would be $12.50. If you had purchased the stock itself, it would have cost you $600 (plus fees) for 100 shares.
The right to buy a stock or futures contract is known as a call option. Your agreed-upon price of $10 a share is called the strike price.
Unlike futures trading, an option is a right, not an obligation. If your stock's price climbed, but not past the $10 strike price, your option would be useless. You would likely let it expire and lose the $12.50 premium.
However, if the stock did indeed climb to $12 a share, you could exercise your call option at $10 a share, then immediately sell at the $12 market value, earning you $2 a share, or 16 times your 12 1/2-cents-per-share investment (minus broker fees).
Or at any point, you could sell the rights to your option for more money than you paid - and never have to actually purchase the stock or futures contract you were betting on.
You could also obtain the right to sell a stock or futures contract at a certain price. This is known as a put option, in which you are betting that the price of the stock will fall. Thus, if you had an option to sell a stock for $5 a share and it fell to $4, you would still be entitled to receive $5 for your shares.
Calls and puts are available on a wide variety of investments on many different exchanges.
Options can be used for speculative purposes to try to achieve a big profit quickly, or for conservative means such as hedging against risk. For example, if you hold many stocks, you might buy some market index puts. If the market falls, your stocks lose value but your puts pay off and soften the blow. Of course, you have to weight the cost of buying the options (including brokerage fees) against the potential gain or loss of the corresponding stock or futures contract.
Sources: The Wall Street Journal Guide to Understanding Money and Markets; The Investor's Encyclopedia; The Only Other Investment Guide You'll Ever Need, Andrew Tobias.
- KIM NORRIS