First I will give a quick overview of stock option. Then I will discuss how they work and what it means. Finally I will review a few common options tactics that are used to make money. Options can reduce risk and amplify returns. I am focusing on American style options.
Stock options are a contract. This contract gives they buyer the right to buy or sell 100 shares of a stock until a certain date. When you buy one of these options you pay a premium. The premium paid on stock options is based on the amount of risk and is related to interest rates (usually).
There are 2 types of options, calls and puts. When you purchase a call you are buying the right to buy a stock for a certain price. This agreement ends on a certain date. It may seem confusing but it is not that bad.
Stock Option: Calls
Imagine you are in a grocery store. You see that apples are on sale for $1 and you want to buy 100 but you do not need them until next week. You want to secure this good price so you talk to the manager and offer to give him $1 for the right to buy the apples at $1 each next week if the price goes up. If the price goes down you will pay regular price. Either way he keeps the dollar.
The next week you show up and the price of apples is $1.25. You pay the manager $1 each so now he has $101 instead of the $125 he would have made otherwise. You save $24 on your apples. Now to put it in terms of stock options, the apples are stock and the $1 that you paid the manager is the premium. The manager took you $1 for the premium because he did not think that the price of apples would be more than $1.01 the next week. He made more than he would have by selling to you last week but not as much as if he had waited until this week. In this situation you both received a good deal.
Now if you had gone back the next week and the price had been $0.85 you would have paid the $85 for the apples and the manager would have kept the dollar. That is the risk you take when you buy calls. If the price goes below the agreed price you lose the premium you paid. You are not required to buy the stock but you are out the money you paid.
So when you buy a call you believe that the price of the stock will be above the strike plus the premium you paid or the break even point. The break even point is important to note before ever buying an option. When a stock is expected to release earnings or have another event the price of options gets much higher and can be much more risky.
Now we will go back to the grocery store. This time you are the store manager. A customer wants to buy the apples for $1 each but not right now. You want to sell them for $1. You give the customer $1 to come back and buy the apples for $1 each next week because you think the price will go down.
When you buy a put you are paying for the right to sell shares at the agreed price in the agreed amount of time. This is commonly used to protect stock ownership from losses. It is also used as a strategy to buy stock. If you sell a put you may end up buying the stock at the strike price. Back to the store example.
When the customer comes back to the store they find that the price of apples has dropped to $0.85. They still have to pay you $1 each. The customer ends up paying $84 dollars for the apples because you gave them $1 for the contract. If the price had gone up to $1.25 they would pay the full price and keep the dollar so they pay $124 for the apples. In this case the manager attempted to limit his losses by guarantee a sale at $1. As you can see options can go either way
Stock Option Trades
The most common Stock option trade is the naked purchase. This is when you simply purchase or sell a single option with the opinion that the stock will move in a certain direction. When you buy a call you are expecting the price of the stock will increase in value. One way to make money with calls is for the stock price has to go up and you sell it before expiration. The other is to wait until expiration. If the stock closes above the strike (agreed price) you will own the stock. You only make money if the stock closes above the price of the option plus the strike price.
The opposite is true for puts. You are expecting the price will go down. You can make money with puts the same way as with calls but you need the price to drop to make money. The alternative may be wanting the stock to close below the strike so you can sell it to the person who sold the put. Puts are often used to protect the investor from losses related to a long position.