What are options?
Options are most commonly associated with stocks and stock indices. There are two types of option: a call option (to buy) and a put option (to sell).
In an option you’re entering into a contract with a vendor to purchase or sell a specified quantity (100 shares per option) of a security at an agreed price – called the strike price – at a certain point in the future.
The vendor, or writer of the option, is contractually obliged to sell or buy the underlying security at the strike price at the expiration of the contract. For this, you – the holder of the contract – will pay a premium to the writer for taking on the risk.
Let's say, for example, you think the stock of Sigma Corps, currently trading at $20 a share, is going to rise over the course of one month. You agree a strike price of $20 with the vendor of your call option, and he charges you $1 per share to write the contract – meaning the total price of the option is $100. That’s 100 shares at $1 a share.
After the month is up, the stock of Sigma Corps has risen to $25 a share. You now invoke your right to buy the shares from the vendor at the agreed strike price of $20 a share, and then sell them immediately on the open market at $25 a share. That’s a gain of $500, less than $100 cost of the option.
This works the other way around too. If you think Sigma Corps’ shares will fall you can take a put option out at the strike price of $20, giving you the option to sell 100 shares to the writer upon expiry. If the shares fall to $15, you buy 100 shares in the market and sell them to the option writer for $20 each.
Again, the biggest danger is that you end up on the wrong side of the bet. If you fail to beat the strike price you are contractually obliged to either buy or sell the shares at a loss.