These days there exist many different kinds of options and other derivatives.

EUROPEAN CALL OPTION

A so-called CALL option gives you the right to buy a specific stock (to exercise your option) at a given date for some agreed upon price. The date is called the expiration date and the price is the strike price.

Call option for IBM stock with expiration date 3 months from now and strike price of $100:

The option gives you the right to buy this stock 3 months later at a fixed price of $100 - independent of its market value. The main point is that - as the name suggests! - this is purely optional, you don't have to buy the stock. So, clearly, if after 3 months the IBM stock is at $110 you exercise the option and buy the stock for $100 as you can immediately sell it again at the current market value and keep the $10 difference. If the market value is less than $100 you just trash your option.

 

note: all this discussion neglects transaction costs that have to be taken into account, too. Buying and selling stocks costs some money.

 

 

The payoff for this call option can be checked out in the pop-up window. Just choose the strike price and you will see the amount of money you get out of the option depending on the value of the stock at the expiration date.

 

Up to now we have - erroneously - assumed that those options are for free. Therefore we could never lose money. But - the option has a price that has - initially- to be paid to the institution that issues this option. However, the price of options varies all the time, so an option - like a stock - is traded on the financial markets. For estimating the payoff we can enter an option price in the window and recalculate the payoff, go ahead and try it yourself!