Underlying Concepts

• Stock options give the owner the right to buy or sell shares of stock at a set price within a set amount of time. The set time frame is a distinguishing characteristic of an option trade vs. a stock purchase. Options are purchased based on your belief that the stock price will rise or fall within the given time frame. If the stock price moves as you expect during this time, you make a profit.
  
  Another distinction is that options require less upfront investment than purchasing shares outright, possibly the biggest advantage to this type of trading.
  
  

Calls and Puts

• There are two types of basic options, "calls" and "puts." A call increases in value as the stock price rises; a put increases in value as the stock price declines.
  
  If you expect a stock to rise in value, you will want to buy a call. If you believe the stock price will fall, you will want to buy a put.
  
  Buying a call will allow you to leverage your potential gain and minimize your initial investment. Buying a put will enable you to profit if a stock declines in value. Your risk is limited to the amount of the option purchase, as opposed to a traditional short sale, where your losses are potentially unlimited. Puts are also used to "hedge" a stock position, which means that if a stock you already own is declining in value but is one you still want to keep, a put option on the stock will increase in value as the stock price declines, which minimizes your overall loss.
  
  In addition to buying options, you can also sell them. When you sell, or "write," a call option, you get paid immediately. You offer to sell shares at a set price for a specific amount of time. If the stock price is at or below the agreed price at the end of the time frame, you keep the option income. If the stock price is higher than the agreed selling price you offered, the buyer will want to take advantage of buying the stock at the below market price, and you will be forced to sell the stock at the agreed price.
  
  The highest-risk option trade is selling puts. You must have an approved margin trading account in order to sell put options because you are agreeing in advance to buy shares of stock if the price falls below your selling price. For this reason, this strategy should be used only with a stock you are willing and able to buy if necessary. The biggest risk is that if these shares are purchased on credit, you will be forced to sell other stock or add more cash to your account to pay back the loan for potentially worthless shares.