- Stock options belong to a family of investment vehicles known as "derivatives." A derivative is a type of financial instrument that derives its value from another. In the case of stock options, the values depend on the values of underlying shares of real stock. An option is simply a contract between two parties, but these trade publicly on the financial markets for nearly anyone to purchase. However, unlike real stock, all options eventually expire, as this is part of the terms of the contract. After it expires, an option contract has zero value and ceases to exist. This is makes it possible to lose 100 percent of the investment.
- A call option gives its buyer the right, but not the obligation, to purchase 100 shares of real stock for each option contract at any time before the option expires. Most importantly is the option's "strike price," which sets the locked-in price for these shares. The contract's strike price never changes. The actual value of the shares at the time of the transaction has no effect on the purchase price. Thus a call option to buy shares for $100 each when they actually trade for $120 each is a valuable and "in the money" option. If the shares rise in value, the call option becomes even more valuable and its price increases.
- A put option gives its holder the right to sell at a predefined strike price. If a stock is falling in value, holders of a put option will see this part of their portfolio increase in value. No matter how low the shares fall, the put option still gives it holder the right to sell at a specific price that doesn't change. Like call options, each put option covers 100 shares as part of its contract terms.
- While stock options allow anyone the right to execute the terms of the contract and trade real shares of stock, many participants simply buy and sell the option contract itself. For example, if the shares rise in value, the trader sells her call option for a profit. But there are other uses. Put options offer a form of "portfolio insurance" for investors who want to hold onto their stock but minimize any damage in the event of a downturn in market prices. By purchasing put options that cover the stocks in their portfolio, they rest assured that they can always sell their stocks at a good price no matter how far they fall. Or, they can just sell the put options directly and receive profits to compensate for stock losses.