How do options work? Options on stock let you bet on the direction a stock’s price is going to move on the stock market. There are two types of options contracts, call options and put options, that you can either buy or sell through brokerages depending on which way you think the stock covered by that option is going to move.
Option contracts specify the type (call option or put option), the underlying stock, the strike price at which the underlying stock can be bought or sold, and an expiration date after which the contract is no longer valid. Rather than going into each one of these in detail (I do so in other articles on this site), I’ll just give you a quick and basic overview that will give you the fundamentals of how do options work.
How Do Call Options Work?
A call option is a contract that lets you buy a stock at a certain price (the strike price) before the contract expires. The strike price for a call option is typically much higher than the current price of the stock meaning there’s a decent chance that the stock won’t ever reach the strike price. However, if it does, you can force the person who sold you the call option to sell you the stock at the strike price and then you can turn around and sell it at the now higher market price to earn a profit.
That’s how call options work for the call buyer. If you’re the call seller, you’re betting that the share price of the stock covered by the option never reaches the strike price letting you profit from the “premium” that the call option buyer pays you to enter into the contract.
How Do Put Options Work?
A put option is a contract that lets you sell a stock at a certain price before the contract expires. In contrast to the above section of this article on how do options work, the strike price is far below the current market price so you buy put options when you expect the market price to drop. If it drops far enough before the contract expires, you can sell the stock at a price higher than the current market price and profit the difference.
When selling a put option, how put options work is you’re paid a premium to agree to buy stock at the strike price if the person who bought your option ever decides to exercise the contract. You sell a put option if you expect the price of the underlying stock to remain above the strike price for the duration of the contract.
So, that’s how options work. There are a wide variety of ways to profit from buying and selling put and call options beyond simply waiting for the contract to expire and hoping that the share price is on the right side of the strike price for you to make money. Those strategies are sometimes complex and, at a minimum, require their own article so I’m not covering them here. This was just the basics of how do options work – check out the other articles on this site for the rest of the details.
