What Is a Stock Option?
A stock option gives an investor the right, but not the obligation, to buy or sell a stock at an agreed-upon price and date. There are two types of options: puts, which is a bet that a stock will fall, or calls, which is a bet that a stock will rise.
Options are a type of financial instrument known as a derivative—their worth is based on or derived from, the value of an underlying security or asset. In the case of stock options, that asset is shares of a company’s stock. Essentially, the option is a contract, an agreement between two parties to sell/buy the stock; the option contract sets the date of the transaction (usually a few months into the future) and the price.
When a contract is written, it determines the price that the underlying stock must reach in order to be “in the money“, known as the strike price.1 An option’s value is determined by the difference between the underlying stock price and the strike price.
Stock options come in two basic categories:
- Call options allow the holder to buy the asset at a stated price within a specific timeframe.
- Put options allow the holder to sell the asset at a stated price within a specific timeframe.