A stock optionStock option A contract that gives you the right to buy (“call”) or sell (“put”) a stock at a set price within a certain period or on a specific date. You don’t have to use the option if you believe you will lose money doing so.+ read full definition is a contractContract A binding written or verbal agreement that can be enforced by law.+ read full definition that gives the buyer the right – but not the obligation – to buy or sell a stockStock An investment that gives you part ownership or shares in a company. Often provides voting rights in some business decisions.+ read full definition at a specific price on or before a certain date. You don’t have to investInvest To use money for the purpose of making more money by making an investment. Often involves risk.+ read full definition 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 optionsOptions An investment that gives you the right to buy or sell it at a set price by a set date. The buy right is termed a “call” option, and the sell right is termed a “put” option. You buy options on a stock exchange.+ read full definition 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 priceMarket price The amount you must pay to buy one unit or one share of an investment. The market price can change from day to day or even minute to minute.+ read full definition.
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 optionCall option An agreement that gives you the right to buy a stock, bond, or other investment at a set price by a set date (within a set time period). Also called a “call.” You buy a call hoping that the stock price will rise and you can buy it for less than its market price.+ read full definition on XYZ Inc. for $3.
- The shareShare A piece of ownership in a company. A share does not give you direct control over the company’s daily operations. But it does let you get a share of profits if the company pays dividends.+ read full definition 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 commissionsCommissions What you pay to a broker or agent for their services. Often called a “sales commission”. For example, you pay a fee to someone who buys or sell stocks or real estate for you.+ read full definition).
You buy a call option when you believe the price of the stock is going to rise. You buy a put optionPut option An agreement that gives you the right to sell a stock, bond or other investment at a set price within a set time period. Also simply called a “put.”+ read full definition 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 priceStrike price The specified price at which the holder of an option can buy or sell the stock.+ read full definition – 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 assetAsset Something of value that a company or an individual owns or controls. Examples: buildings, equipment, property, a car, investments, or cash. Can also include patents, trademarks and other forms of intellectual property.+ read full definition. Learn more about stock options from the Derivatives Institute of the Montreal Exchange.
Stock options are not for everyone. They are complex investments that can be very risky.