Options

Contracts giving the right (not obligation) to buy or sell at a set price by a date.

Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. The underlying asset is most commonly a stock, but can also be an index, exchange-traded fund, or commodity. Sellers of options, on the other hand, take on an obligation to fulfill the contract if the buyer decides to exercise their right. There are two primary types of options: calls and puts. A call option gives the holder the right to buy the asset, while a put option gives the holder the right to sell it. To acquire these rights, the buyer pays a non-refundable fee called a premium to the seller. The predetermined price at which the transaction would occur is known as the strike price, and the final date the option can be exercised is the expiration date. Investors use options for two main purposes: speculation and hedging. Speculators use options to gain leveraged exposure to price movements with a smaller upfront capital requirement than buying the actual stock. Hedgers use options like insurance policies to protect an existing portfolio against adverse price movements. A major pitfall for retail investors is that options are wasting assets; because they have an expiration date, their time value decays daily, meaning an investor can easily lose 100% of their premium if the underlying stock does not move as expected in the required timeframe.

An investor believes Company XYZ stock, currently trading at $50, will rise. They buy a call option with a strike price of $55 expiring in one month for a premium of $2 per share. Since standard stock option contracts cover 100 shares, the total cost is $200 ($2 x 100). If the stock rises to $60 before expiration, the investor can exercise the option to buy 100 shares at $55 and immediately sell them at the market price of $60. The gross profit is $5 per share ($60 - $55), or $500 total. After subtracting the $200 premium, the net profit is $300.