Options strike most as exotic investment transactions. And some option strategies can be risky. But stock options can also be used in ways that are not risky. Call options give you the right to buy a stock at a certain price (the strike price) on, or before, a certain date (the expiration date). So if you want to speculate that a stock will go up in a short period of time you can buy call options. This is a risky investment strategy – though it can pay off well if you speculate correctly.
Someone has to sell the call option. The seller gives the buyer the right to buy a stock at a certain price by a certain date. A speculator can do this and take the risk that the price will not rise to the level where a person chooses to exerciser their option. The also carries a significant risk, as if the stock price rises the speculator that sold the option has to either buy the option back (at a significant cost) or provide the stock (which they would have to purchase on the market). In order to trade in options you must be approved by the broker (at least in the USA) as an investor with the knowledge, finances and goals for which options trading is appropriate.
An investor can also sell an option to buy a stock they own – this is called selling a covered call option. This means you get the price the speculator is willing to pay to buy the option and may have to sell the stock you own if the person holding the option chooses to exercise it.
Lets look at an example. Lets say you own some Amazon stock. It has been doing very well and lets say you are considering selling it. One option is just to sell it. Today for example you could have sold Amazon for $165 a share (or $16,500 for 100 shares). Lets say you didn’t want to sell at $165 but thought $175 would be a price you would be willing to sell your shares for. You could put in a limit order to sell when it reached $175 (and if it did you would received ($17,500). Or you could sell an option to buy your 100 shares of AMZN at $175 by December 18th of this year. Today you could have sold that option for $675.
If Amazon doesn’t reach $175 you just made $675 and otherwise your portfolio is identical to what it would have been otherwise. If it goes to $175 then you can have it bought at $175 and then you make ($17,500 + 675 = $18,175). Now it is a bit less straight forward than this. If you put in a limit order and it goes up you will sell your stock and have your cash. Selling someone the option to buy it doesn’t require them to buy it. The price could go to $180 and they keep waiting (often options are not exercised – especially since normally they are mainly used by speculators). If it then fell to $165 before December 18th you still own it (and it is worth less than if you sold at $675). If the price is above $175 on December 18th then it will be exercised.