Stocks are fairly straightforward. To make a profit, you would buy stocks at a lower price and sell them at a higher price. Options are a slightly complex product. In this post, I would try to explain how options work.
Remember that the stock market is a zero-sum game (meaning one person’s profit is someone’s loss). Options are similar to insurance. A person buys auto insurance for $x/month which states that under certain situations insurance company would pay $25k. If those conditions meet then the insurance company would have to pay $25k. If not then the insurance company would collect $x every month.
Let’s see how this applies in the stock market. Assume that you have 100 shares of stock X. You bought it for $10. Right now, it’s trading at $50. Congratulations on your trade. You know this company well. Company X is going to announce their quarterly report in 10 days. If the company made good money then the stock would be much more than $50. If not then it would go down in value. You want to ensure your profit of $40. Your goal is to find someone who buys stock x from you at $50/share in case if the stock loses its value. If the company reports that they are making much more money than your expectation then the stock price would go up (let’s say $60) and you want to continue to hold it. What if you could insure your stocks?
This is where options come into the picture. You find a person who is selling an option that says “Buyer can sell 100 shares of X at $50 within 10 days.” You pay $2 to the person who is willing to option seller.
Situation-A Following figure shows what would happen if the company underperforms and stock hits $40.
Note that though the stock is trading at $40, the option seller has to buy the stock at $50. Because the seller sold an agreement to buy stocks from the option-buyer. If the option-buyer decides not to execute the option then the option-seller would be lucky.
Situation-B On the other side, if the stock hits $60; the following would happen
Note that, instead of executing the option. Option-buyer would sell stocks at $60 by placing normal order.
In the above situation, we assumed that the option buyer has 100 shares. What if the option buyer does not have 100 shares?
- In condition-A, the option-buyer would buy stocks at $40 and sell them to the option-seller at $50
- In condition-B, the option-buyer would not do anything.
In nutshell, the option-buyer gets an opportunity to back out. Option-seller would have to accommodate the buyer’s request no matter what. The contract discussed above is called the put option.
Let’s consider you don’t have any stocks of company X. You think that company X would do well. Your goal is to lock in the current price of the stock of company X which is $50.
Situation-C The following figure shows what would happen when the stock hits $40
Note that in the above case, the option-buyer won’t execute the option.
Situation-D The following figure shows what would happen when the stock hits $60
Note that in above case, option-seller has to sell the stock at $50 to the option-buyer.
The option described in situation-C & D is called the “call” option. Remember that when you buy options, you have the option to back out. If you decide to sell the option then you are committed to the option-buyer.
I hope that the reader of this post would get clarity on
- buy v/s sell option
- call v/s put