What Are Options and How Can Investors Use Them?

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Options are part of an asset class known as "derivatives," which means they perform based on the movement of an underlying asset.

For purposes of our discussion, we'll focus on equity, index and exchange-traded fund (ETF) options, which are among the most actively traded of these vehicles.

Formally, options are contracts between two parties that give buyers the right but not the obligation to purchase or sell a predetermined number of shares of an underlying asset at a specific price on or before a specific expiration date.

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What are options?

Generally speaking, investors who expect the underlying asset to rise would buy a call option, which gains value as the associated shares increase in value.

Call options allow the holder to buy shares of the underlying asset at the price stated on the contract (the "strike price") on or before the contract's expiration date, provided the stock trades above that price.

Investors who expect a stock to decline would buy a put option, which gains value as the underlying share price falls.

Holders of put options enjoy the right to sell shares at a contract's strike price on or before its expiration date, so long as the price of the underlying stock declines.

How are options priced?

Most standard options contracts are based on 100 shares of an underlying stock, which is crucial to know. Options prices are quoted on a per-share basis, so a call option quoted at 75 cents will actually cost $75 to buy (75 cents per share multiplied by 100 shares per contract).

Occasionally, corporate events such as acquisitions, mergers, divestments, stock splits and other scenarios can result in adjustments to options contracts based on the underlying equity.

Depending upon the nature of the adjustment, the underlying asset and/or the strike price may be changed to reflect the new value of the options contracts. Nonstandard options will be indicated by an updated symbol within the stock's options chains.

How do options work?

The purchase or sale price fixed in an options contract is called the "strike price." Strike prices vary based on the price, trading range, share volume and popularity among options traders of the underlying stock.

Options strike prices may be listed as tight as 50 cents or as wide as $5 to $10 depending on liquidity and demand for specific contracts.

Similarly, a more heavily traded and liquid stock will have a wider variety of expiration dates to consider.

While a less actively traded stock may have only a few monthly options expiration dates listed at one time, the most popular stocks and ETFs will have weekly or even daily options expiration series available to trade.

There are a few potential outcomes for the buyer of the options contract. The options contract can be sold to close – for a profit or a loss – at any time prior to expiration. This closing transaction, once filled, ends the trade and any related terms of the options contract.

Alternatively, the buyer might choose to exercise an in-the-money option.

A call is "in the money" when the price of the underlying stock is above the strike price of the options contract. A put is in the money when the price of the underlying stock is below the strike price of the options contract.

An in-the-money call or an in-the-money put can be exercised at any time up to expiration under the terms of the options contract.

The call option holder has the right to buy 100 shares of the underlying stock at the strike price, and the put option holder has the right to sell 100 shares of the underlying stock at the strike price.

Many options contracts are never exercised and are either closed out prior to expiration or simply left to expire worthless. But brokerages may automatically exercise in-the-money options at expiration, so it's important for investors to actively manage their puts and calls.

How do investors use options?

Investors can use call options and put options to speculate on directional moves for the price of the underlying stock.

And both types of options can be sold against existing stock or cash positions to generate income or to acquire additional shares at favorable prices.

Options can also be used to hedge equity or ETF holdings and manage risk within a broader portfolio. Options strategies that rise in value when the value of underlying assets fall can help mitigate potential losses.

Elizabeth Volk has been writing about the stock and options markets since 2007. Her analysis has been featured on CNBC, published in Forbes and SFO Magazine, syndicated to Yahoo Finance and MSN, and quoted in Barron's, The Wall Street Journal, and USA Today.