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
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.
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