There are two basic types of stock option calls and puts.
Calls give you the right to buy and puts the right to sell. A
three month call on ABC stock at $10 gives me the right to buy
ABC at $10. Any time during the next three months, even if the
stock has risen to $12. Of course, I wouldn't exercise that
right unless the stock was above $10. I'd simply buy the stock on
the open market puts work the same way except on the sell
side. So in this example, options are a lot like
insurance, you have all of the upside of the stock rises above
$10. But none of the downside below. Why would anyone give you
that right? The answer is you pay them. Just like insurance.
The price you pay is called a premium. The price at which the
option can be exercised is called the strike price. Well,
exactly how much do you have to pay? This is the problem which
mathematical models can answer quite precisely. It depends on
the strike price compared to the actual price of ABC stock. The
closer ABC is to the strike price, the more likely the
option will be in the money. And therefore the more expensive the
option. It also depends on the inherent volatility of ABC. If
it's a risky stock, and more prone to big moves either up or
down, the greater is the upside potential, and therefore the
more expensive the option will be. Remember, we don't care
about the downside potential. Because we're talking about
options, just the upside. The premium also depends on the risk
free rate. By combining puts and calls of different terms and
strike prices, we can implement virtually any custom strategy we
desire. You'll sometimes hear terms like straddles, strangles
and spreads, which refer to common compound option
strategies, you probably don't need to know what these are.
Important thing is to realise the potential for options to
fine tune portfolio strategies. For example, suppose I own ABC
stock, and I'm willing to tolerate losses of up to 5%. But
not beyond that, while still fully participating in the
upside of the stock goes up. Using options, I could do that.
We've already talked about a primary way that options are
used, which is as insurance. But what are some of the other ways
up to now we've looked at things from the point of view of the
person buying the option. But what about the seller, many
investors sell options as a way of enhancing returns. If I
already own ABC stock, I might sell a call. So I give someone
the right to buy my stock at a strike price, say $3 above the
current stock price, and pocket the premium. If ABC goes down,
well, I would have owned it anyway. And at least I have the
premium to cushion my loss. If it goes up, say $5, I get the
first $3 of price appreciation, plus the premium paid to me by
the buyer of the call. True I've missed out on the last $2 of
price appreciation. But I've still done very well. As I
mentioned mathematical models do a very good job of estimating
fair value for options. So another application would be to
look for outliers, arbitraging cheap options against expensive
ones of the same stock, or against the stock itself. One
final application to talk about is a little complicated, but it
illustrates the power of options. You can create
synthetic stock positions. These use a combination of calls and
puts to produce the same payoff profile as owning the underlying
stock while committing much less capital