Options, Futures And Fantasy Football (2)

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In the last blog we introduced options.  I had indicated that we would discuss another form of derivative in this blog, but I think we should first explore options in depth.  There are two types: calls and puts.  Both types of options are traded on various exchanges, and the options fluctuate in price in line with the changes in the price of their underlying asset,  Traders on the exchange will buy or sell both types of options, puts and calls, throughout the trading day as the prices of the underlying assets vary.  There are options traded around the world representing almost every type of commodity and financial asset.   For purposes of this blog, we will look only at options on publicly traded stocks.

A call option gives the purchaser of the option the right to purchase one hundred shares of a stock for a fixed price (the "strike" or "exercise" price) for a set period of time (the "life" of the option).  The purchaser pays the going market price for the option.  The purchaser of the call is betting that the price of the underlying asset, such as a stock, will increase beyond the strike price.  The purchaser can either exercise the option and then sell the stock at a greater price in the market or receive the value of the option above the strike price.  In either case, the purchaser has made money.  As we know, for every buyer, there must be a seller.  The seller of a call option receives the option price paid by the purchaser.  The seller is betting that the price of the stock does not exceed the strike price by the expiration of the "life" of the option.  If the market price of the stock does not exceed the "strike" price by the end of the option's "life", the seller of the call option keeps the money paid by the purchaser for the option.  Aside from accepting the risk, the option price received by the seller is "free" money.  If the market price of the stock at the end of the time for exercise remains below the strike price, the purchaser has lost only the money paid to the seller for the option.  If the market price of the stock at the end of the exercise period is above the strike price, the purchaser "calls" for the stock at the strike price from the seller of the option and resells it at the market price for a profit.  Assuming the seller of the option had to go into the market to buy the stock to fulfill the option contract, the seller of the option has a loss, i.e., the current stock price which he or she had to pay for the stock less the option price the seller received at the beginning of the contract and  the strike price, i.e., the amount paid by the purchaser upon exercise of the option.  The allure of the call option for the purchaser is that the amount of profit is hypothetically unlimited, but the amount of the loss is limited to the option price paid at the beginning of the contract.

A put option is the exact opposite of a call option.  A put option gives the purchaser of the option the right to sell one hundred shares of a stock to the seller of the option for the strike price for the life of the option.  The purchaser of a put pays the market price for the option.  The purchaser of a put option is betting that the price of the stock will decline below the strike price.  The purchaser can then exercise the option; buy the stock in the market at the lower price and "put" it to the seller of the put option at the strike price for a profit.  Just like the seller of a call option, the seller of a put option hopes the option will expire without being exercised, allowing him or her to pocket the price paid for the option.  If the seller of a put option bets wrong, he or she is obligated to buy the stock at the strike price which would be above market price at the time of exercise.

So, to make things simple, if you think a stock price is going to rise, you can buy the stock itself, you can buy a call option on the stock at a strike price you think the stock price will ultimately exceed or you could sell a put option which, if the price rises, will expire unexercised and you can pocket the option price you received.  If you think a stock price is going to decline, you can "short" the stock itself (I will explain this in a later blog), you can buy a put option on the stock at a strike price you think the stock price will decline below or you can sell a call option, which, if the price declines below the strike price, will expire unexercised and you pocket the option price you received.

In any of these cases, the trader is risking  a lot less money than if he or she went into the market to buy a stock or to "short" it.  In the case of the purchaser of either a call option or a put option, the loss is limited to the price paid for the option.  The risk of loss is hypothetically unlimited for the seller of either type of option; however the option price represents extra money received for "free" by a seller who is convinced the stock price will act as the seller anticipates and the option will expire unexercised.

This is a link to a website with more information on options.  In the next blog we will discuss another form or derivative, futures.

Comments are always welcome.