What is the point of options?



I understand that buying an option gives you the right to sell a certain stock at the strike price, but what is the point of this? How can you profit from guessing right, and is there any advantages to options that stocks don’t have?

In: Economics

An option is simply the “option” to buy at a certain price regardless of the current trading price. If the current trading price is higher than your strike price then you make money. If it’s lower then you are known as being shit out of luck.

> I understand that buying an option gives you the right to sell

*Certain types* of options that is. Some give you the right to purchase stocks at a certain price in the future for example.

> the right to sell a certain stock at the strike price, but what is the point of this?

If the current price of the stock on the open market is less than the strike price of the option, then you can purchase the stock and sell it immediately at a higher price while pocketing the difference. The point is you make money.

> How can you profit from guessing right

Beyond the obvious situation explained above, options are also useful for something called “hedging”. Basically they are mechanisms to avoid risk. If you are in a situation where you want to potentially profit from a stock you own going up in price but if it went below a certain price it would be disastrous, you could purchase an option to sell at a price just above that point. Now the maximum amount of money you could lose from the stock value changing is limited.

> is there any advantages to options that stocks don’t have?

Again, in addition to the above situation of hedging you could potentially trade in options without tying a lot of money up owning stocks themselves. For example if we consider the situation where you purchase the option to sell at a certain price, betting that the stock will reduce in value, you don’t have to keep a bunch of money invested in owning the stocks themselves in the interim. All you spend is purchasing the option and that is going to be far less than the cost of the stocks themselves.

Suppose you’re a farmer, and you’re pretty sure you’re going to harvest at least 75,000 bushels of corn, but maybe as much as 100,000. But you need to know, in advance, how much money you’re going to get for it, so you can plan about how much money you’re willing to spend optimizing your crop.

You can sell contracts on 75,000 bushels (for delivery at harvest time) right now, and lock in a price, but what about the 25,000 maybes? You can’t guarantee that you’ll be able to deliver them. So what you can do is buy put options on that amount. That guarantees that, even if the bottom falls out of the market, you’ll get at least the strike price for them (minus the options’ cost). If it’s not a good harvest, you can just let the options expire.

Let’s imagine a stock that’s currently trading at $50/share.

To buy a bundle of 100 stocks would cost you $5,000. If the stock’s value increased to $75/share, you could sell your shares for $7,500. You would make a $2,500 gain on a $5,000 initial investment, or a 50% return. On the other hand, if the stock’s value dropped to $25/ a share, you would lose $2,500.

Now let’s consider how options work. To buy a call option (giving you the right to buy a certain number of stocks, at a fixed price) on 100 stocks with a strike price of $50/share costs **a lot less** than $5,000. For purposes of this example, lets say those options cost $500. These options are **not** ownership of stock; you’re literally paying $500 just to have a guaranteed price, and you still need to come up with the $5000 to buy the stocks themselves. (though you could borrow the money and then immediately sell the stocks if they’re worth more than the strike price)

So now, you’re buying call options on 100 shares of stock with a strike price of $50/share for $500. If the stock price goes up to $75/share, you would make a $2,500 gain on a **$500** investment or a **400%** return. On the other hand, if the stock price goes down, *no matter how much it goes down*, you can only lose the $500 you paid for the options.

I like to look at options as insurance. If I own 100 shares of a stock, that stock price might drop a lot and I will loose money. I can insure that by BUYING a put option . This gives me the guarantee to sell the stock at a fixed price, called the Strike Price. Without the put, I can only sell at market price. This gives me some loss protection.

On the other hand, I might short a stock – essentially betting the price will go down by owning negative shares. I really want to make sure that stock doesn’t go up too high, or I loose money. Buying a call option gives me the guarantee to buy the stock at a fixed price instead of buying at market price. So when the price of the stock goes way up, I can use the option to buy shares and cover my position with less of a loss.

Options have premiums, just like insurance. Insuring a stock position for a long time and a lot of value costs a lot, short time and low value costs less.

It’s a simple way to look at it.

I insure my car by buying car insurance. I don’t want to get into an accident, I don’t want to use my insurance. But if I do, I can significantly reduce my loss by ‘exercising’ my insurance that I paid for. Without the insurance l, I’m on the hook for the entire mistake.