Investing in stock options starts with agreeing to a stock option contract.
The term "contract" in this case seems intimidating. You're not legally obligating yourself to buy shares at the contract price, you're simply showing interest in that stock option.
To agree to a stock option, you pay the current market price of those shares. Any time before the date listed on the contract, you can buy those shares at the strike price mentioned in the contract-- no matter how much they're actually worth.
The goal is to enter contracts that let you buy shares for cheaper than what they rise to be worth by the expiration date.
You're presented with a call option to buy 100 shares in RandomCompany X (RCX).
The strike price is $100 per share for the next 3 months.
The expiration date for you to make your decision to buy or not is 3 months. The current premium for shares at RCX is $75.
Hang on, there are some unfamiliar words here. Let's break this down a little more.
Put Option vs Call Option
There's some unique terminology involved in trading stock options:
- Expiration date - The time limit put on an option contract
- Strike price - The price of the shares in the contract
- Call option - An offer to buy shares, in the hopes those shares will be worth more by the expiration date
- Put option - An offer to sell shares at a pre-determined price. If you have shares of a stock, put options shield you from any losses below the strike price.
- Premium - The current market price of a company's shares and the amount you pay for the rights to a stock option
You profit when the shares you've bought become worth more than the strike price you agreed to. If you can estimate how quickly a company's shares will increase in value, winning small profits isn't that difficult.