If you follow markets, you may have heard someone, at some point, talking about making put or call orders on a security. Other than making the inference that puts or calls are a different kind of way of holding a stock, you’d probably be very confused. That inference isn’t completely right, but it does capture the essence of what an option is.
The name “option” actually describes what an option is very well. An option deal has two participants: a buyer, called a holder and a seller, called a writer. A holder will buy a call or put on a stock, and they can make the decision to sell or buy. A writer must buy or sell, if the holder decides that they would like to. The holder has the option of finishing the deal, while the writer must listen to the holder.
There are two kinds of options. A call is a type of option that allows the holder to buy a stock at a fixed price at some fixed point in the future. A put is a type of option that allows the holder to sell a stock at a fixed price at some fixed point in the future. An example will make sense of this concept: I buy some weekly puts in $LNKD on February 3rd, 2016. The option costs me $10 per share, called the premium of the option, for a strike price (the price at which I can sell the shares) of $191. My option expires on February 10th, 2016 at price $101. I exercise my option and sell my shares, then buy to cover, making me a profit of $90 minus the option cost of $10 to give me a net profit of $80 per share. A put is less risky than an outright short position (renting, then selling a stock and buying it back at a lower price), because you know how much money you will lose at the start. Though an option gives less reward, because options have a cost.
This is an example of an options chart:
In a sense, a writer and a holder are gambling against each other when buying an option. A holder must have a very good reason to buy an option, because a stock will need to rise or fall a sizeable amount to make any profit on an option. Options can be the way a smart trader makes a steady profit and a way to trade with less risk.
An important aspect about options is that you can place options on indexes like the S&P 500 ($SPY). This is a great way to make money off of bearish (pessimistic) or bullish (optimistic) predictions of the market. You can also place options on the volatility of indexes ($VIX) so if a market is turbulent, the volatility index will rise and your pockets will grow larger.
Just because options are less risky than flat-out holding long or short, they are generally going to lose you money. An option will have to outperform the option cost, which is usually higher than a few dollars, though it is entirely dependent on the price of shares. Options are very situational, and are great for when someone is certain something will go down, but looks to eliminate some of the risk involved in making large trades. But here’s the advice anyone will give you: don’t go trying options until you know what you’re doing.