Options are essentially contracts between two parties that give holders the right to buy or sell an underlying asset at a certain price within a specific amount of time.
An option’s value is tied to the underlying asset, which could be stocks, bonds, currency, interest rates, market indices, exchange-traded funds (ETFs) or futures contracts. Options are securities themselves, like a stock or bond, and because they derive their value from something else, they’re called derivatives.
There are two main types of options contracts: calls and puts. Owning a call gives you the right to buy the underlying asset; owning a put gives you the right to sell that underlying asset. An easy way to keep them straight is to remember that a call would “call” an asset away, while a put would “put” it to someone else.
How options work
Options investors generally have an opinion on the future price of an asset, believing it will rise or fall. In the case of stocks, which we’ll focus on here, you might choose a call option if you think a stock will rise, or a put option if you think it will fall. Typically, options contracts are very short, such as 30, 60 or 90 days, but can have expiration dates of up to a year.
An options trade always has two sides: a buyer and a seller. Sellers, also known as writers, are obligated to buy (with puts) or sell (with calls) the underlying security if the buyer decides to exercise the option, or if the option expires in-the-money. Buyers have the right — but aren’t obligated — to buy or sell the security at a predetermined price (strike price) by a certain date (expiry date).
One options contract is generally based on 100 shares of the underlying stock. For example, if the option on a stock is trading at $1, the cost of one contract (commissions excluded) would be $100 (100 x $1).
The value of an option is based on the stock’s current market price and volatility of the stock. An option’s intrinsic value (its in-the-money value) and the length of time (time value) until expiry are also reflected in its overall value.
Similar to stocks, options trade on exchanges. However, while stocks can give you part ownership of a company, options don’t. Options don’t come with voting rights, nor do they pay dividends like many stocks do.
Styles of options
There are two styles of options contracts: American-style and European-style. American-style options are the most common and can be exercised anytime up to and including their expiration date. European-style options can only be exercised on their expiry date.
Options typically cost much less than the underlying asset, but still offer exposure to the price movements of that asset without owning it.
Options are flexible and can support a variety of profit and risk-minimization strategies. In the case of stocks, for instance, options can help you:
- Protect stock holdings from a decline in market price
- Generate income from your existing portfolio
- Acquire stock at a price below the current price
- Profit from a stock price’s rise or fall
- Use leverage to grow your portfolio
But remember, there are risks with any investment. It’s a good idea to weigh the risks before you get started to determine if options are a good fit for you.