Stocks are securities that provide owners with fractional ownership in a company. Investors profit from purchasing stocks through a mix of dividends and appreciation (rising share prices). If an investor purchases a stock at $10 and, at the end of the year, it has grown to $13, the investor can profit $3 (30% return on investment) by selling the stock at the higher price. But if that stock fell from $10 to $7 and the investor sold, they would incur a loss of $3 (30%).
Options are rights to buy or sell stocks (or other assets) at specific prices, called “strike prices,” on or before a certain date, the “expiration date.” Options amplify the associated risks and return by adding a form of leverage.
For example, an investor might elect to buy a call option contract (the right to purchase a security) for $1 at a strike price of $10 per share. If the stock price is above the strike price, they can exercise the option and profit. If the stock is worth $13 on the stock market in the future, they can exercise their call option to purchase the stock for the strike price of $10 and then immediately resell the stock for $13 per share. In this circumstance, the investor has generated $3 in proceeds and $2 in profit, including the cost to purchase the call option ($1). This is a 200% return on the $1 investment where just purchasing the stock (as shown above) produced a 30% return.
However, if the stock fell and was never higher than the strike price of $10 before the expiration date on the call option, the option would be worthless. The investor would lose all of the money invested for a 100% loss, even though the stock might have only experienced a small loss or stayed flat at $10.
Trading stocks and options is the process of buying and selling these securities. Both allow investors to benefit from the performance of companies and their stocks. But options trading amplifies both risk and reward.