When it comes to investing, it's nice to keep your options open. Options allow you to make a bet on the direction of an underlying investment such as a stock, bond or market index without actually buying that investment. In addition to investing in options, Wall Street follows options trading to glean investor sentiment about the market as well as individual stocks. The days that certain options expire can have a volatile impact on the broader market. There are countless ways investors use options -- from using them as a hedge to avoid a big loss in a stock to making very risky bets that a stock will rise or fall -- but they revolve around two simple choices: options to buy and options to sell. (For more on the many ways investors use options, please see the Getting Started entry on Options Strategies .)
An option to buy is known as a call; calls are bought when investors think the value of the underlying stock is going to rise. Here's how a call works: An investor pays a premium, which represents a fraction of the value of the underlying investment, for the right to buy a stock at a preset price, known as the strike price, within a given time frame. After buying the call options, you have two choices. Let's give an example to make it clear what happens with the money. We'll say you bought 10 call options for 100 shares each of XYZ Co. for a premium of $500. The stock's price was $35 a share when you bought the option, and the strike price is $40. The options in this case expire in three months. Hold the options until maturity (the day they are set to expire), then trade them at the strike price. If the stock is above the strike price, you make money if the difference exceeds your premium. So, if you exercise the option to buy the stock at $45 a share, the 1,000 shares would be worth $5,000 more than the strike price. Subtract the $500 premium, and you made $4,500 (minus fees you pay to your broker). You also have the option to trade the options before it expires, if you're happy with the profit. Let the options expire without exercising them. Say the stock stays at $35 the whole time, or drops lower, it wouldn't make sense for you to trade them because you would lose thousands of dollars. So, you let the options expire and all you lose is your $500 premium. Investors also buy options when they think a stock or other security is going to decline in value. An option to sell a stock is called a put. When you buy put options, you buy the right the sell the underlying investment at a set strike price within a given time frame. The way buying put options works is similar to buying calls, except you hope for the underlying investment to go down. If so, you trade for a profit. If not, you swallow the premium.
Selling options works differently. Since the buyer is the one holding the cards, you are obligated to sell if the buyer wants to exercise the options. Investors can sell options to buy and options to sell: If you sell someone the right to buy an underlying investment from you, it is known as writing a call. If you sell someone the right to sell an underlying investment to you, that's called writing a put. Two common ways to sell calls and puts vary greatly in degree of risk: writing covered options, and writing naked options. When you write a covered call, you are selling someone the right to buy a stock or other underlying investment that you already own at a strike price. When you write a naked call, you sell an investor the right to buy something from you that you don't own. Naked calls and puts are aptly named, because they leave you exposed to huge downside risk. For instance, if you wrote a naked call allowing someone to buy 1,000 shares of a stock from you at $30 a share, and that stock rises to $35 a share, you have to buy the 1,000 shares at $35 a share, then sell them to the buyer for $30 a share. In other words, getting naked isn't prudent.