A stock option is kind of a vague idea for most people to understand right off the bat. You’re not actually dealing with owning a piece of a company like with a stock, but you’re actually dealing with the “option” to own a stock which is a piece of a company.
A stock option is actually defined as “the right to buy or sell a company’s stock at a certain price”.
I think that the best way to help understand stock options is to use an analogy:
I live in Central Florida, where we get battered with hurricanes every couple of years. Let’s say I own a hardware company, and I know that if we get hit with a hurricane this year, I could sell 500 gas generators to people who want to keep their refridgerator and appliances running while the power is out. The problem is that as soon as a hurricane comes, my suppliers will be bombarded with demands from other companies, and I probably will only get 10 or 20 generators to sell. Plus I don’t want to buy 500 generators now, because if we don’t get hit with a hurricane I’ll be stuck with 100s of generators in my warehouse taking up space and a lot of my money.
So what do I do? I go to the manufacturer and I tell him that I’ll pay him $1,000 in return for a guarantee of the right to buy 500 generators the next hurricane season at MSRP. Even if, all the other hardware stores in Florida are asking him to send generators, he will send the first 500 from his warehouse to me, whenever I ask.
Now, if we don’t get hit with a hurricane this year, I’m out $1,000, but at least I’m not stuck with 500 generators I can’t sell. The big benefit comes though if we do have a hurricane. I’ll probably be the only one in town with generators to sell to everyone, and I can probably raise the price a little too. I’ll make a killing.
Stock options work this way too. It essentially lets you benefit as if you “own” the stock, without actually having to buy it. For example, if I buy call options on Bank of America for next month at a $10 strike price, I’ll have to pay around $.50. If the stock goes up to $20, I can excersize my option to buy the stock at $10, and turn around and sell it for $20, when I only spent $.50. If the stock tanks, I’ll only be out of $.50.
I hope this helps clear some confusion in the complicated topic of stock options.
[...] actually a stock you can buy or sell, but are “derived” from actual stocks. Just like stock options, they allow you to speculate whether a stock will go up or down at some point in the future. Not [...]