A stock option is a contract that gives the buyer the right – but not the obligation – to buy or sell a stock at a specific price on or before a certain date. You don’t have to invest directly in the stock. You can just buy the option. One option usually gives you the right to buy or sell 100 shares of a stock.
2 types of options
1. Call options
Call options give you the right to buy a stock at a certain price by a certain date. You buy call options if you think the price of the stock is going to rise. You make money if you:
sell the option for a higher price than you paid for it, or
exercise your option to buy the stock and then sell it at a higher market price.
If, at the expiry date, the option is in the money (the market price of the stock is higher than the exercise price) and you don’t exercise the option, it will be exercised for you. If the option is out of the money, it will expire worthless.
Example – You buy a call option on XYZ Inc. for $3.
The share price of company XYZ Inc. is at $40, so your call option allows you to buy shares at $40 until the end of next month.
Meanwhile, the share price jumps to $50.
You exercise your option by buying the shares at $40 and then selling them at the current market price of $50.
You’ll make $7 a share — the difference in the share price less the $3 premium for buying the option (less any commissions).
You buy a call option when you believe the price of the stock is going to rise. You buy a put option when you think the price is going to fall.
2. Put options
Put options give you the right to sell a stock at a certain price by a certain date. They’re often used as a hedging strategy. You buy a put option if you think the price of a stock you own is going to fall. If the stock rises in value, you can sell your shares for a profit and let the put option expire. But if the price falls, you can exercise the put option and sell the stock at the higher price specified by the put option.
You can also make money if you sell the option for a higher price than you paid for it.
Some terms to know
Call (or put) holder – someone who has bought a call (or put) option
Call (or put) writer – someone who has sold a call (or put) option
Expiry date – the date after which the option can no longer be used or exercised
Option premium – the price of the option
Strike price – the specified price at which the holder of the option can buy or sell the stock
Stock options are known as derivatives because they derive their value from an underlying asset. Learn more about stock options from the Derivatives Institute of the Montreal Exchange.
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