Call Option

There are basically only two types of options: call options and put options.

A call option gives the holder the right but not the obligation to buy a certain stock (underlying security) at a certain price (strike price) by a certain date (expiration date).

Example: If you had reason to believe that the XYZ Zipper Company was undervalued and would rise in price in the short term, you could purchase a call option.

There are other factors involved (addressed in later pages), but generally speaking, if the stock's share price moves higher as you anticipate prior to the expiration date, you would be able to capitalize on the move at a much higher rate than if you'd simply bought the shares outright.

Let's suppose that XYZ is trading at $25/share. You purchase a call with a strike price of $30 and an expiration date one month out. You purchase the contract for $1.25 (and since each contract represents 100 shares, you multiply the $1.25 by 100 to arrive at an actual cost of $125, excluding commissions).

You now have the right, but not the obligation, to buy 100 shares of XYZ anytime between now and expiration for $30/share. With the stock trading at $25/share, there's obviously no incentive to purchase the stock (i.e. exercise the option). But if there's some kind of catalyst, and the stock rises so that it's trading at $35/share, it's a different story.

You could exercise the option, and purchase those 100 shares at the $30 strike price for an additional $3000 (excluding commissions). Factoring in the $125 you already paid for the call, your total cost would be $3125, or $31.25 for each share. With the stock now trading at $35/share, that gives you a $375 net gain.

It's unlikely that you would actually exercise the option, however.

In the above example, the call you originally purchased for $1.25 would increase in value as the stock price rose. Although there are different factors involved in the pricing of options, the very short version is that you could simply sell the call option back and more or less make the same $375 gain without ever having to own the stock.