An option is the right to buy or to sell a stock at a particular price. For a small fee, the stock market will give investors the right to sell a stock at an agreed upon price, for a period of time. Here’s an example…
XYZ stock costs $30. Bob expects it to go down in price during the recession. He pays a small fee and he receives the right (called an option) to sell the stock for $30. Then, just as he expected, the recession causes the stock to go down to $20. The stock is now worth $20 and Bob has the right to sell for $30! He could purchase the stock for $20 and then sell the stock for $30. This would allow Bob to make a profit.
You might be thinking,
“Great! Bob had the right to sell a $20 stock for $10 more than it’s worth! Who cares? No one in their right mind is going to buy it from him! So he’s stuck with it!” Are you thinking this? :-)
Actually, there IS someone who will buy it from Bob for the higher amount. The person who wants to do it is an employee, of stock market exchanges, called a “Market Maker.” Market makers are the people you see in the pictures of the New York Stock Exchange, waving their papers, screaming prices, shaking hands, and clapping at the end of the trading day. Their job is to take deals, like the one Bob offered. In fact, the more of these deals they take, the more money they tend to make.