How is trading options different from buying and selling stocks?
In: Economics
Conceptually: an option is the right to choose whether to do something. Hence, it is an *option*, quite literally, as you have the option to do something. Optionality comes at a cost, because on the other side of the option is an obligation. See how they’re mirrored? If you have the right to choose to do something, then the other party has the obligation to reciprocate.
In trading, an option is a right to either **buy** or **sell** a stock, at a certain **price**, at a certain **time**. A call option is the right to buy a stock. A put option is the right to sell a stock.
Example: *TSLA $900 CALL MARCH 18, 2021*: A TSLA call option lets the holder buy Tesla stock. if the call option is for March 18, then the holder can buy the Tesla stock any time on or before March 18. $900 is the price of the transaction, if it happens. This option gives the holder the right to buy 100 shares of Tesla at $900, on or before March 18, 2021.
What about the other end of the transaction? If you buy an option, someone has to sell it to you. Symmetrically, since you get to choose whether you want to exercise the option, the seller must fulfill the demands of the buyer.
We take the same example as above. If I sold you that option, I am obligated to sell to you 100 shares of Tesla at $900, on or before March 18. I am locking myself into this obligation, therefore I am going to charge a certain amount of money for it. How much should I charge? It depends on how much I expect the stock to move (volatility), how many days are left, how close I am to losing money, etc.
So, March 18 rolls around and its time to see whether our options did anything.
* If TSLA = $900, then I can buy 100 shares from the market and sell it to you for the same price. You paid me money for no reason.
* If TSLA < $900, you wouldn’t even ask to buy shares from me because you can get them for less than the contract price
* If TSLA > $900 + $option price, then you would profit because now you can immediately sell the shares you buy from me. Remember I am obligated to sell you 100 shares at $900. If TSLA is $1000, then you can turn around and make a quick thousand bucks.
Therefore an option is a ‘derivative’, as in its value is derivative of the value of the *underlying*, which is the stock itself. There is a lot to options pricing and trading strategies, but think of it as you are buying or selling **contractual rights to do something**
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