What Are Options?

Options are a useful tool for investors looking to bet on a directional price move, generate income and hedge portfolio positions.

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Options are part of an asset class known as "derivatives," which means they derive their value from an underlying asset. For our purposes here, we'll focus on equity, index and exchange-traded fund (ETF) options, which are among the most actively traded.

Formally, options are contracts that give the buyer the right, but not the obligation, to buy or sell a predetermined number of shares of the underlying asset at a specific price on or before the option's expiration date.

What are options in simple terms?

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.

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Traders who expect a stock to decline would buy a put option, which gains value as the underlying shares fall. Put option holders gain the right to sell shares at the contract's strike price on or before the expiration date, so long as the expected stock decline plays out.

The range of price points available on a stock's listed options, known as "strike prices," will vary depending upon the stock's price, range, share volume and popularity among options traders. Strike prices may be listed as close together as 50 cents, or as far as $5 to $10 apart, based on liquidity and demand for the contracts.

Likewise, more heavily traded and liquid stocks will have a wider variety of expiration dates to consider. While some less actively traded securities 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.

How do options work?

Most standard options contracts are based on 100 shares of the 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 x 100 shares per contract).

Occasionally, corporate events such as acquisitions, mergers, divestments, stock splits and more may result in adjustments to the option contracts associated with the affected equity. Depending upon the nature of the adjustment, the underlying asset and/or the strike price of the options may be changed to reflect the new value of the contracts, and the nonstandard options will be indicated by an updated symbol within the stock's options chains.

There are a few potential outcomes for the option buyer. The contract can be sold to close – whether 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 holder might choose to exercise an in-the-money option. Calls are in the money when the underlying stock is above the option's strike price, while puts are in the money when the underlying stock is below the option's strike price. 

An in-the-money put or call can be exercised at any time up to expiration under the terms of the option contract – that is, the call option holder has the right to buy 100 shares of the underlying at the strike price, and the put option holder has the right to sell 100 shares of the underlying at the strike price.

Many option contracts are never exercised, and are either closed out prior to expiration or simply left to expire worthless. An option that's in the money at expiration may be automatically exercised by the brokerage, so it's important for traders to manage call and put positions actively ahead of their expiration date.

Along with directional speculation, call and put options can also be sold against existing stock or cash positions to generate income or acquire shares. Options can also be used to hedge equity or ETF holdings within a broader portfolio.

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Elizabeth Volk
Contributing Writer, Kiplinger.com

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.