If you’ve been around investors or financial advisors, you may have heard about something called an option. Options are contracts on stocks that can guarantee a buy or sell price. Option contracts are made between investors. They have a cost (called a premium) and they can be exercised by the buyer once the stock that the contract was purchased on reaches a certain price (called a strike price). That price acts as a trigger because it makes the option contract valuable. Option contracts come in lots of 100 so 1 contract = 100 shares.

Huh?

There are two different types of option contracts: Puts and Calls

Puts are guarantees from one investor to buy stocks at a certain price from another investor.

Calls are guarantees from one investor to sell stocks at a certain price to another investor.

Example Put:

Let’s say I own 100 shares of XYZ currently at $25.00 per share. I read in the news that some bad stuff might be happening and I am worried that XYZ’s stock might fall. I don’t want to sell XYZ because the actual market reaction to the news hasn’t been negative yet, but I do wish that I could somehow hedge against financial ruin if the stock price drops. So instead I buy a put from another investor. This put guarantees that I can sell XYZ to the seller of the put for a strike price of $17.00 per share if it reaches or falls below that amount. I’ve paid a premium for this contract so if XYZ doesn’t reach $17 I’m out my premium, but if it falls below $17 I can actually make more money exercising the put than I would have selling it in the open market.

Example Call:

I own 100 shares of ABC currently at $20 per share and it is really doing well. I think I want to buy more, but I’m concerned that this isn’t the right time. I wish that I could wait and see if it goes up in value but not actually have to pay the increased price in order to buy it. Enter a call option. In a call option, I pay a premium for the chance to buy ABC at a strike price of $25 a share. I can watch ABC go up in value and, when it hits $26 or $27 a share, I can exercise my call option and buy it for only $25.