Options are derivative contracts that allow buyers of the contracts to buy (using calls) or sell (using puts) a security at a chosen price (strike price) on or before a specific date (expiration date). Option buyers are charged an amount called a “premium” by the sellers for the ability to do this. Should market prices go against the buyer, the most that can be lost is the original premium paid for the contract. In contrast, option sellers (writers) assume open-ended risk, which is why they demand this premium.
There are two types of options—calls and puts.
A call option gives the buyer the right, but not the obligation, to buy the underlying asset on a certain date (expiration) at a certain price (strike).
A put option gives the buyer the right, but not the obligation, to sell the underlying asset on a certain date (expiration) at a certain price (strike).
Options are leveraged instruments, i.e., they allow traders to amplify the benefit by risking smaller amounts than would otherwise be required if trading the underlying asset itself. A standard option contract on a stock controls 100 shares of the underlying security.
The current price of Google (GOOG) stock is $1,200. If a trader had $5,000 to invest he could only buy 4 shares of stock. If the stock price went up 5% in the next month, the trader would make $240. A 5% return on the capital invested.
Now, a call option with a strike price of $1200 that expires in about one month is trading for $25, or $2,500 per contract. The trader can buy two call options with his $5,000. Because the option contract controls 100 shares, the trader effectively made a deal on 200 shares. If the stock price increases 5% to $1260, the calls will expire in-the-money and worth $60 per contract. Subtracting the $25 paid for the calls leaves a profit of $35 per contract. $35 x 200 shares equals a $7,000 profit, which is a 140% return on the capital invested.
That's the power of leverage.
Of course, there must be a downside.
Risk/Reward: Of course, there must be a downside. The trader's potential loss from a long call is the full amount of the premium paid. So in this example if the stock went down just $1 to $1199, the calls would be worthless and would result in a loss of the full $5,000, whereas the stock trader would have only lost $4. So options greatly increase potential profit, but generally also increase the potential risk, even though the maximum risk is limited solely to the premium paid.
A put option works in the opposite way a call option does. A put option gains value as the price of the underlying decreases, and loses money if the underlying rises.
Risk/Reward: Potential loss is limited to the premium paid for the option. The maximum profit from the position is capped since the underlying price cannot drop below zero, but as with a long call option, the put option leverages the trader's return.