In the bluntest terms, option contracts are limited term up (calls) or down (puts) bets that are 100:1 (for stocks) leveraged that traders and speculators can buy and sell.
Each contract is worth 100 shares of that particular stock, with the option to buy or sell the stock at the strike price. The strike price is the over/under price that determines whether or not the option contract will have value by its expiration date: usually, the third Friday in a designated month.
Example:
Facebook (NASDAQ: FB) is trading at 150 In October. If one thinks FB will reach 160 by mid January, she could buy 100 shares of FB at a cost of $15,000. That might be a bit out of budget for some investors to allocate for a single stock, and a 10-point gain would yield a profit of $1,000 before commissions, or 6%. On the other hand, a single call option contract of FB January 150 might be at 5, or cost $500. If FB did indeed go to 160 before or by mid-January, the call option would be "in-the-money," i.e. over the strike price of 150 for 10. As long as the contract was either sold (realizing a 100% profit before fees) or exercised (purchasing the stock for 150 when the current price is now 160, thereby locking in the profit).
On the plus side, option contracts are very leveraged, but the cash outlay is small enough to manage for a singular speculation without risking a significant part of a portfolio budget, and can multiply one's profit if a number of contracts are obtained and the bet is correct. On the negative side, the risk is high, since the premium value erodes with each calendar day. Stagnancy or a trend against your bet's direction can result, and often does, in loss of the entire trade amount, if not carefully monitored.
Option contracts are considered derivatives, and are also the mechanical basis for all other kinds of derivatives trading, most notably in futures. The futures market includes options, indexes, interest rate securities swaps, commodities, foreign exchange, warrants, and even more obscure markets, such as carbon credits, tax credits related to film and TV production, and others.
Related or Semi-related Video
Finance: What are stock options in 90 se...0 Views
Finance allah shmoop what are stock options in ninety seconds
or less Here's a stock ibm not the tech company
This one makes an anti constipation drug It's trading at
one hundred eighty bucks a share Okay so here's an
option of buy a share of ibm anytime in roughly
the next three months For one hundred ninety dollars a
share it's called a call option If you really believe
the ibm will go to say two hundred dollars a
share in the next three months well you'd be what's
called ten dollars in the money then or then have
a stock option or call option with a strike price
of one hundred ninety dollars which would then have intrinsic
value of ten bucks a share On the other end
of the buy sell desk is the gal willing to
sell you that call option for three bucks Three bucks
a premium So gut check time Would you pay three
dollars for the right to buy a share if ibm
for ten dollars higher than where the stock's trading now
today Meaning that to break even in the next three
months the stock has to trade all the way up
from one hundred eighty dollars a share to one hundred
ninety three dollars a share jobs for you to get
your money back but it goes to two hundred two
share Well if you sell that option you'll have invested
three bucks a share for a net return of seven
bucks in just three months or less And yes we're
ignoring commissions and taxes here because well in problems like
this or just a in the book but three dollars
into seven only three months Yeah that's a great score
You'd have more than doubled your money And on an
annualized return basis that's over a nine hundred percent dish
return really good score but with a much more likely
case that you spend three bucks to buy the option
and it expires totally worthless And then you've lost your
entire investment in that option So that's a call option
It's evil twin is a put option So whereas a
call options the rightto by a security to set price
by a certain set date a put option is the
right to sell that option We'd go into more detail
here but we're promised ninety seconds
Up Next
What is a put option? A put option is a type of contract that lets the investor sell shares of a stock at a certain price and within a window of ti...
What is a call option? A call option is a type of contract that lets the investor buy shares of a stock at a certain price and within a window of t...
The intrinsic value of an option is the share price of a stock minus its strike price - i.e. the "in the money" amount.