Through an option, a trader can have the right, but not obligation, to buy or sell securities at the set price before the expired date of the option. The process of buying and selling options is similar to the buying and selling stock.
However, even when options quoted in per share, you can only buy it in 100 share lots. For instance, a call option is quoted at $1, but you have to pay $100, since they sell it in 100-share lots.
Here are the two types of options, calls and puts.
Call Option
Call option gives traders the right to buy a particular security at a certain price on or before the expiring date. Traders buy a call option when they anticipate the price of a particular security to rise before the option reach its expiration date of the option contracts.
For instance, you believe that the price of XXX company stock will rise, its current price is $25. At that moment, you have two options, to buy the stock or buy the call option.
If you choose to buy the call option, you will get the right, but not obligated to buy the shares of XXX company in the next 90 days for $26. That option can cost you around $100.
If your expectation is correct, the stock price rises, for example $30 per shares, then you gain profit. Since you can buy that shares for $26 per share and sell it immediately to gain $3 per share.
Or else, you can simply sell the call option for direct profit without undergoing that complicated process of buying and selling the stock.
But if you make the wrong expectation and the price of the stocks stay or fall, you can simply let the option expire. That way you only suffer $100 loss.
Also read: LEAPS Strategy Over Stock Investment
Put Option
On the contrary of call option, put option gives you the right to sell particular security at a certain price on or before the expiration date. Traders usually buy a put option if they expect the price of stock to fell before the expiration date.
With the same XXX company as the example, if you feel like the price of the shares will go down from $25 per share, shorting that stock will be the only option. Yet, that can be risky if your expectation is wrong.
Thus, you can buy put option for $100 ($1 per share). That will give you the right to sell 100 shares at $24 per shares.
