Stock market options can be seen as something very confusing and scary if you are new to the stock market. The idea behind options is however in itself not very confusing. It is simply a tradeable contract where one part, the issuer, promises to buy or sell a stock or other item at a certain point in the future for a certain price.
In exchange for this promise the issuer get the sale price when initially floating the options on the market. Options can be non-transferable, but since this article focuses on the stock market we will ignore non-transferable options. Stock market options are not the same as binary options which has become a popular online investing form.
Let me give an example of how a stock market option can work:
“A” believes that the stock in a company will go down. He therefor issues an option where he promises to sell a share for a price 10% above current market price in six months time. (He offers a buy option, i.e. the buyer of the option can buy his share at the price specified in the future). “B” believes that the stock will go up so he buys the option from A for 5 USD. A is now 5 USD richer and B has the right to buy the share in 6 months for a predetermined price. If A is right and the stock price does go down or at the very least up less than 10% during this time, the option is valueless and A made USD 5.
The option is in this case without value since it is cheaper to buy the share on the open market than by using the option. If the stock on the other hand gains more than 10%, then the value of the option will be the difference between the price specified on the option and the price of the share on the open market. If this difference is more than 5 USD then B, the buyer, makes a profit. If it is above 10% but the difference is less than 5 USD A still makes a profit albeit a smaller one. Options can be bought and sold at any time on the futures market. The price will fluctuate based on the price development in the underlying company as well as due to the future prospects of the company.
Never loose more than invested
A person who buys a option can never loose more than the money they invested. A person who issues an options can in theory loose an infinite amount of money. Someone who wants to offer an option, something that is never recommended for regular investors, will hence be asked for large securities from their bank or stock broker. A normal investor who is offered to take part in an options offering should decline, as this is associated with high risk and might cause severe looses for you.
Purchasing options can on the other hand be a good a good way of leveraging your investment portfolio. This is true even for small investors. If you choose to invest in options it should however be done using money you can afford to loose as you will loose your entire investment if the market develops unfavorable. If the market on the other hand is favorable you can gain several hundreds or even thousand percent in a short amount of time. Options is in other words a leverage instrument and gains as well as losses will be bigger than if you invest the same amount in the underlying stock.
A similar instrument to the option is the future. The future is also a contract between two parts about buying and selling a stock for a certain price at a future date. The difference is that a future is binding for both parties. The buyer must buy and the seller must sell, unlike with an option where only one party is bound by the contract. The buyer in a future is referred to as long and the seller as short. These terms are to reflect the future expectations of the parties for the stock. The seller thinks it will fall and is hence short in the stock (compare to the term shorting a stock, i.e. selling stock you do not own in the hope to buy them back later at a lower price to repay the debt to whomever borrowed you the share that you sold) and the buyer thinks the stock will go up and is hence long in the stock.
Options and futures can be issued for any item, not just for shares and other financial instruments.