An option contract that gives the holder the right, but not the obligation, to buy 100 shares of an underlying security within a certain time frame, at a certain price (the "strike price") is a "call option" (or a "call). The concept is like leasing a particular car. You have the right to buy this car at the end of the lease term, but instead of paying the whole premium upfront, as in buying an option, you pay the premium (in monthly installments) to the financing company. Your lease expires at the end of the term, and like with an option, you may exercise it, (buy the car or buy the stock), or simply let it expire (give back the car or do nothing on the options side.) That is how simple it is.
The opposite of a call is a "put option" (or a "put"). A put gives you the right to sell 100 shares of an underlying security within a certain time frame, but not an obligation, at a certain price (the "strike price"). You are guaranteed a sale at the predetermined strike price if the security falls below the strike price.
The premium for that option will be lower , when there is less time remaining until an option expires. For example, the premium for an option that expires in a month would be lower that the premium for an option that expires in two months. If you would want a downside protection (by buying a put) for an infinite period of time, the premium of such a put option would equal the price of the security itself.
Some options basic points:
Currently options could be traded on four exchanges:
The American Stock Exchange trades put and call options on common stocks and broad market, industry sector and international indexes, exchange traded funds and HOLDRS.
Founded in 1973. The Chicago Board Options Exchange is the world's largest options marketplace and the pioneer of listed options.
Founded in 1790, the PHLX was the first stock exchange to be established in the United States and trades approximately 2,000 stocks, 1,200 equity options, 16 index options and 8 currency options and 6 currency futures.
Founded in 1862, the Pacific Exchange was the first exchange in the world to build and operate an electronic trading system. Trades more than 1,200 stocks options. It is one of the world's leading derivatives markets
The OOC (Options Clearing Corporation) has been founded in 1973 and keeps records of all outstanding contracts for all U.S. exchange listed equity options. Basically it knows who is long (owns) and who is short (sold without owning) every outstanding contract.
Placing an options order is the same as placing a stock order. You call your broker (if you use a live broker) and tell what you want to buy or sell how many contracts and you state the price (limit order) or you can place a market order (the best available price at the moment the order comes to the trading floor).
For the most brokers you have to meet certain criteria before they open an account. You must have necessary funds to cover any margin requirements. First of all your broker will require you to open an margin account. Even if you are not going to borrow money from your broker you still have to do it if you want to trade options.
After you met margin requirements your broker ill send you a several agreements where you find "Characteristics and Risk of Standardized Options" and "Understanding Stock Options" that are very useful to read especially if you only started to trade.
After your account is opened you can place an order with your broker.
When volatility is at high levels and the stop loss point on a particular stock is at about the same price as the cost of an option, Options are the preferred vehicle. Also when volatility increases the option premium, the time spreads are the highest. A contract that gives the holder the right to buy 100 shares of the underlying stock within a certain time frame is called "Call Options". The concept is similar to leasing a car. One has the right to buy this car at the end of the term and instead of paying the whole sum upfront as in buying options, payments are made to the financing company in monthly installments. When the lease expires at the end of a term and just like an option, the buyer may wish to continue (buy the car or buy the stock), or let it expire (give back the car or do nothing on the options side). It's as simple as that.
A contract, that gives the holder the right to sell 100 shares of the underlying stock within a certain time frame and at a certain price, is called the "Put Options". The investor will be guaranteed a sell at your strike price if the stock falls below this price (called "strike price"). Obviously the amount to pay will be less if the time bought for protection is shorter. A one month premium costs less that a two months premium and so on. In theory, if a downside protection for an infinite time period is wanted, then the premium will equal the price of the stock.
Since the buyer has the right to exercise or sell his/her puts at any time prior to the options expiration (the period one has purchased for) both of these definitions are for buying puts and calls. A very important distinction is that a buyer has the right while a seller is obligated.
Naked options trading is very risky - many people lose money trading them. It is recommended contacting your broker or investment professional to find out about trading risk and margin requirements before getting involved into trading uncovered options.