Stock Options
This is a bit disorganized and in need of development.
Stock options are contracts that give the buyer the option to purchase or sell a stock at a specific price (called the "strike price"), regardless of the current market price of the stock, until a specific date.
The most common form of options is the "American" option, in which the price is specified, buyer can exercise his right at any time up to the expiration date, and the transaction is in stock and cash only. Other forms of option exist, and can get quite weird, but do not seem to merit much attention.
Option contracts are written in lots of 100 shares, but prices are quoted on a per-share basis - hence an option contract quoted at $2 actually costs $200 to purchase.
PROFIT POTENTIAL
A call option gives the buyer the right to purchase a stock at a specific price, even if the current price is higher. The profit to the buyer is in obtaining the stock at the option price, then selling at a higher market price.
As an example, if a buyer purchase a call option at $5 and the price of the stock goes to $6, he can exercise that option: he buys the stock at $5, sells it at $6, and generates a $1 profit (less the premium paid for the option).
A put option gives the buyer the right to sell a stock at a specific price, even if the current price is lower. The profit to the buyer is in obtaining the stock at the market price, then selling it at a higher option price.
As an example, if a buyer purchases a put option at $5 and the price of the stock falls to $4.00, he can exercise that option: he buys the stock at $4, sells it at $5, and generates a $1 profit (less the premium paid for the option).
SELLER'S PERSPECTIVE
The motive for a seller to offer such an option is a fee (called a "premium") that the buyer must pay for the contract. Ideally, the stock will never move above or below the price specified in the contract before the option expires.
Another note: the seller does not necessarily need to hold the stocks that he is contracting to sell - but if a buyer calls his option, the seller must purchase shares on the market to fill the contract he signed if he does not hold them. The potential for loss on uncovered (or "naked") options trading are considerable, and some brokerages may not allow customers to write contracts unless sufficient shares or cash is on account to cover the exercise of sold options.
OPTIONS AS HEDGING
Other than speculation, options can be used to hedge against an investment. If an investor is uncertain of a stock, they can buy a "put" option as a stop-loss measure. The benefit to doing so, above merely placing a stop order to sell on the market should the price fall, is that the option guarantees that there will be a buyer for the quantity the seller wishes to unload, and that time is not critical (the investor can hold the stock to see if it recovers and exercise the option later if it does not).
OPTIONS AS SPECULATION
Options are attractive to speculators because of their relatively low cost and high return as opposed to a stock. Typically, an option that is a few dollars above or below the price of a stock sells for a small fraction of the cost of the stock itself, so a speculator can buy options on a larger number of shares than he could afford to buy, maximizing his profit.
Options are also risky, in that they have a fixed lifespan and become worthless after their expiration date. Technically speaking, they are worthless the day they are purchased, and only gain value if the stock price goes above of falls below the option price.
OPTIONS STRATEGIES
There are a handful of strategies for employing options as a means to maximize profit or minimize loss, some of which are detailed below. I preserved the original names (even the goofy ones) for reference.
Call Spread
This describes buying one call option at a lower price, and selling another at a higher price. The profit from selling the second option offsets (but does not entirely cover) the cost of the first option.
The net result is that the investor's costs are mitigated (the profit from selling the higher call option offsets, but does not entirely cover, the cost of buying the lower one), but their profit is restricted to the difference between the two options.
For example, a buyer purchases a call option at $2 and sells a call option at $4.
If the price rises to $3 but no higher, the buyer can exercise his option and generate a $1 profit. However, if the price goes above $4, the person to whom the buyer sold a call option may exercise, meaning that the investor will need to exercise his option to buy at $2, but will be compelled to sell to the second buyer at $4 (by virtue of the contract he sold), so his profit is limited to $2 regardless of how high the price rises.
Generally, the buyer should not exercise his option until the option he has sold expires, or he may be in a position where he must buy stock at the market price (rather than his option price) to satisfy his contract with the person who bought the second option, which may negate his profits.
Put Spread
This is similar to the Call Spread (above), only instead of call options that become valuable when the price of a stock increases, it involves put options that become valuable when the price of a stock falls.
Straddle/Strangle
A "straddle" or "strangle" describes buying a call option and a put option on the same stock. Fundamentally, the buyer turns a profit if the stock goes over the strike price of the call option or under the strike price of the put option.
This strategy is used when a price is expected to be volatile, such that it will either rise or fall from the range between the options, and the difference between the market price and the strike price will cover the cost of the premiums, plus generate a profit above that level.
A straddle involves buying both options at the same price, such that one will always be "in the money" regardless of how the stock moves. A strangle buys the options at different prices, such that if the stock does not move out of the range between them, the investor stands to lose on both options.
In rare instances, high volatility will cause a price to rise and fall within the option period, such that the investor can cash in on both ends of the straddle/strangle. This virtually never happens.
Butterfly
A butterfly strategy employs both a call spread and a put spread, such that the investor is indifferent to the direction in which the stock moves but, at the same time, mitigates his costs and profits by selling options at slightly higher/lower levels than the ones which he purchased.
Collar
A collar strategy can be used as a way to prevent losses without incurring expense, but also has the side effect of preventing profits beyond a certain level.
To employer a collar, the investor purchases actual shares of stock, then buys a put option to minimize his loss and sells a call option to cover the cost of the put option.
In effect, if the price falls below the put option, the seller can exercise his option to sell the shares he owns at a fixed price, limiting his exposure. However, if the price rises beyond the strike price of the call option, another party will force him to sell his shares at that price, such that he will not gain the profit from selling them at the market price.
An investor who employs this tactic should not exercise his put option until the call option expires. Doing so could put him in Dutch if he exercised his put option when the price dipped, then the price soared and the person to whom he sold a call option exercises, such that he is compelled to buy at market price to satisfy the call option.
TERMS RELATING TO SPREADS
The following terms are often used to describe spreads - but to be clear, these terms are not "strategies." but qualities that the strategies above may be said to have.
Vertical
A vertical spread consists of multiple put or call spreads on the same security, such that several ranges are created in which profit can be generated by exercising an option one has purchased, each of which is offset by the possibility that someone else will exercise an option one has sold.
Debit/Credit
These terms also apply to put and call spreads, depending on the premium prices of the options that were bought or sold. In the case that neither option can be exercised, the investor makes a profit on the credit spread and loses it on the debit spread.
Calendar
A calendar spread is merely a call spread or a put spread in which the duration of the options differs, decreasing the likelihood that the person to whom he has sold an option will be able to exercise if volatility increases or decreases over time.