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 Call Option?25 Views
finance a la shmoop. what is a call option? option? option, where are you? okay
yeah yeah. not phone options, call options. and a close but no cigar. a call option [man smokes in a tub of cash]
is the right to call or buy a security. the concept is easy the math is hard.
you think Coca Cola's poised for a breakout as they go into the new low
calorie beverage business. their stock is at 50 bucks a share and you can buy a [man stands on a stage as crowd cheers]
call option for $1. well that call option buys you the right
to then buy coke stock at 55 bucks a share anytime you want in the next
hundred and 20 days. so let's say Coke announces its new sugarless drink flavor
zero it's two weeks later and the stock skyrockets to fifty eight dollars a
share. you've already paid the dollar for the option now you have to exercise it. [man lifts weights]
so you buy the stock and you're all in now for fifty five dollars plus one or
fifty six bucks a share and your total value is now fifty eight bucks. well you
could turn around today and sell the bundle that moment, and you'll have
turned your dollar into two dollars of profit really fast. and obviously had the [equation on screen]
stock not skyrocketed so quickly well you would have lost everything. still you
lucked out and now you're sitting on some serious cash, courtesy of your call [two men in a tub of cash]
options. as for Coke flavor zero turned out to be nothing more than canned water.
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The intrinsic value of an option is the share price of a stock minus its strike price - i.e. the "in the money" amount.