Let’s use an example:
Imagine you have a toy car that you want to sell to your friend, but you’re not sure if your friend will want it or not. So, you offer your friend an option for $2, to buy the car from you for $10 within the next week. You promise that during this week, you won’t increase the price, and you won’t sell this toy car to anyone else either. Your friend agrees and pays $2 for the option to purchase the car for $10 within the week.
Your friend now has two choices: they can either exercise the option and buy the car from you for $10, or they can choose not to exercise the option and let it expire.
In finance, options work in a similar way. An option is a contract between two parties that gives the holder (buyer) the right, but not the obligation, to buy or sell an underlying asset (such as a stock or commodity) at a specific price (strike price) within a certain time period (expiration date).
What is the difference between a call option and a put option?
A call option gives the holder the right to buy an underlying asset at a specific price within a certain time period, while a put option gives the holder the right to sell an underlying asset at a specific price within a certain time period.
Our toy car ELI5 example above is a call option.
A put option, would be if you (the seller) aren’t sure if you want to sell the toy car to your friend. In that case, if your friend approaches you to buy the toy car for $10, you may instead pay him $2 for the option to give yourself another week to think and play with your car before deciding if you’d like to sell it for $10. This is called a put option.
How can a call option be used in the stock market?
Let’s say you buy a call option for AAPL shares with a strike price of $50 and an expiration date of one month. This means that you have the right to buy AAPL for $50 within the next month. If the stock price goes up to $60, you can exercise the option and buy the stock for $50, then sell it for $60, making a profit of $10 per AAPL share. However, if the stock price stays below $50, you can choose not to exercise the option and let it expire, in which case you lose the premium (price paid for the option).
Options can be used for various purposes, such as speculation, hedging, and income generation. However, they can also be risky and complex, so it’s important to understand them fully before trading them.