Here is how a common type of options work, called “call” options. In the real world, this deal below would be completed using a computer wherein the buyer and seller never meet, but this way you can visualize the transaction.
Let’s say Henry owns 100 shares of XYZ stock, and today, the shares trade for $34.00 per share. John comes along and offers Henry this deal:
Henry, I’ll pay you $1 per share [$100] if you’ll give me the right anytime in the next 90 days to buy your 100 shares of XYZ stock for $35.00 share [a dollar more than the stock is currently trading for]. Deal?
Henry agrees to the deal, and they shake on it.
John is betting that XYZ stock price will increase because he’s offering to pay $100 just for the right to buy Henry’s shares for more than they cost today! Henry is betting the opposite because if the stock price remains under $35.00, no matter what, he gets to keep John’s $100 without outlaying of cash.
Forty-five days into this contract, XYX stock trades for $38.00 per share. John still has the right to buy Henry’s shares for $35.00. John could now go to someone else, e.g., Sally, and sell his right to buy Henry’s 100 shares for more, e.g. $3 each, or $300.
John has tripled his money in only 45 days. He paid $100 and sold for $300. Henry keeps this $100, but he lost the profit from the stock price increase he would have enjoyed had he not sold the call option to John.
Look out for Part II where we’ll explain how call options could benefit your own investment strategies.