An Option is what is called a derivative. Think of it as a bet made on a stock. So, its payoff depends on what the stock does; hence it is a derivative. There is a large variety of options, and many details on how they are priced, traded, etc. We will cover some basics only here. (This is by necessity a very incomplete account. Do read the last paragraph.) Also, we discuss only the American versions of these.
Two most common forms of options are the CALL and the PUT.
Note: Each CALL or PUT is a contract on 100 shares ! Also, you need to be qualified by your broker to be able to trade options. Go to http://www.cboe.com and you can find out more than you may ever want to know about options.
CALL:
A call is a right to buy a specific stock at a specified price (strike) on or before a specified day (expiry) for which you pay up front a price (premium).
Example: Suppose I believe that Apple (stock symbol AAPL) is really beaten down at 430.50 at the end of 6/14/2013 but believe it will rise higher, to say, 525 by the end of the year. I could buy 100 shares of AAPL and wait to the end of the year to see what happens. But then I need a capital of $43,050 and am risking a big amount. What if I buy a call on AAPL with strike 450 and expiry Jan 14, 2014 ? We can see that it is priced at $25.59 today, and to do this we only need $2,559 (plus trading costs of course; my broker charges me 7.50 for a trade and an additional few cents for each contract). As an example of a place where you can get information on option prices, I cite http://www.finance.yahoo.com. Go there just enter the ticker name AAPL for getting a quote, then click on the left margin for Options, choose an expiry date and out comes a table; it is that simple. WARNING: the price you get may not be exactly what you see here since option prices change fast, and there is a spread between "ask" (what sellers want) and "bid" (what buyers are willing to pay)
Suppose I buy such a CALL.
Now essentially I have the right to buy 100 shares of AAPL at 450 by exercising my CALL anytime between now and the expiry date or do nothing at all and let my investment on the option go to waste.
How do I make money? You make money by either selling back the call itself since its value changes as the stock price changes. You can do this again through your broker. Another way you could make money is by exercising your option. Of course, you won't exercise your option unless the stock price is above the sum of your strike price (the price you will pay to buy the stock) and cost of the option, in which case you can make a profit by immediately selling the stock you are buying (again you have to factor in trading costs). If the stock price is above strike on the date of expiry, your CALL will be automatically exercised without an active exercise on your part. In practice, buyers of CALLS seldom exercise, they trade them and make their money. Since options are highly sensitive, if the stock price goes up even by a small percentage points, the option holder can make a big percentage gain. But he can lose big too although his losses are limited to the purchase price of the option plus cost of trading. There are sites that give estimates of the rate of change of CALL price for each dollar change in the stock (Delta, as they call it) and things like that. So decisions like whether to buy, what to buy, with what strike and expiry, at what price, what to do with what you bought - all these require quite a bit of analysis parsing much information. (Who said it is easy to make money?)
These are the essentials of a call and buying a call (going long). The seller (who is going short) of the CALL gets his money immediately, but unlike you who have a right (you may or may not exercise), she ends up with an obligation to deliver the stock if and when you demand it. Why would someone sell a call ? May be they think the stock won't hit the strike price before expiry and they can earn something on their holding which otherwise is doing nothing for them. They may also be doing this to hedge (to give themselves a small cushion from drop in price of the stock) through the premium they have collected.
If the guy who writes (sells) the CALL has the stocks to cover it, it is called a covered call. But some write CALLS without even owning the stock (a naked call), and wow, that is risky, is it not ? What if someone wrote the above call for 450 and the stock went to 1000 dollars? He may end up having to buy it at 1000 to satisfy your demand to get it at 450 since they have given a contract to sell at that price. Naked calls etc are clearly in the realm of speculation. I stay away from them totally.
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PUTS
A PUT is the opposite of a call. The buyer of a PUT has the right to demand that the person who sold (wrote) the PUT buy the stock at a stipulated price (strike) anytime until the expiry' For this right, the buyer has to pay a premium up front. People buy PUTs on stocks they hold if they think stock price could go down, and they want to bail out with at least some minimally guaranteed sale price if that happens. Buying a PUT is a bearish move - you believe the stock price will go down.
The details and logistics are very similar to that of a CALL except that payoffs etc work the other way.
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You can get a feel for how the prices of the above change by strike, expiry etc by looking at the options tables and comparing various entries.
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A final word: Usually brokers won't authorize you to trade options unless you can demonstrate that you have some experience in investing and have the financial ability to take the risks associated with options. This is unfortunate in some way because the small investor who may only want to use it for hedging (protecting oneself from big losses) through options is cut out. But then, like many other things, some of these systems are geared to make the rich richer. Stay away from options if you are not reasonably thorough with stock trading or if you are not willing to learn quite a bit about options and options trading. Not losing money is more important than making it for successful investing; when I say this, I mean on your portfolio and not on every trade, since even the pros are unable to do the latter.
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