What Are Options? Definitions and Examples

Interested in options trading? Learn about the different types of stock options and other key definitions that you need to know and understand before getting into the complexities of options trading.

What Are Stock Options?

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Stock options give someone the right to buy or sell a particular stock at a specific price within a set period of time, although they are under no obligation to do so. The price that the stock is set at is called the strike price, and it determines whether the trader should exercise, buy, or sell, the option. While options trading can be highly complex, investing in stock options is also a great way to limit your potential losses when you are trading stocks. 

What Are Call and Put Options?

There are two different kinds of options: call and put options. A call option gives the options trader the right to buy a stock at the strike price within a period of time. The put option gives them the right to sell the stock at a specific price on or before a specified date. 

How Call Options Work

Options traders buy call options if they believe that the price of a stock on the open market is going to go up. Because they have the right to buy the stock at the strike price for a period of time, if the price of the stock moves above the strike price, then the value of the option goes up. The owner of the option can sell that option for a profit or exercise their option to buy the shares. They could also buy the shares and then sell again for a profit. 

For example, let’s say an options trader buys a call option at $10 per share, and the price on the market goes up to $15 per share. The trader can sell the option for a $5 per share profit or buy the shares for the cost of $10 per share and then sell them for a profit. If the price on the market drops below $10 per share, then it’s not worthwhile to exercise their option because the stock can be purchased for a lower price on the market.

How Put Options Work

An options trader buys a put option if they believe a specific stock is going to go down in price. The put option gives the trader the right to sell an underlying asset at a specific price before the option expires. The options trader pays a premium for the right to sell the stock. If the price of the stock moves below the strike price, then the value of the option goes up. Like the call option, the options trader can either sell the option or exercise the option and sell the shares.

The person who is selling the put options, also known as the writer, gets the premium that the put buyer pays for the option to sell. While they have the guaranteed income from the premium, they also carry most of the risk, since they could be obligated to sell the stock at substantial losses.

It’s important to understand the risks of options trading and the different strategies before getting into trading options. Call and put options are just two terms that you should be familiar with.