Why do we use Options
Let’s say that, based on whatever analysis you apply in your selection process, you feel a particular stock is going to go up in price.
So, what can you do?
Well you could Buy the stock outright and pay the going price for it. Typically, this is what most stock traders do. They buy the stock and hope it will go up. If it goes up and the buyer sells, he/she will realize a gain.
On the other hand, if the price falls below the purchase price and he/she sells, the buyer will suffer a loss. In addition to the fact that the probability of a stock going up or down at any point in time is 50/50, the stock buyer must pay the the full price at the time of purchase to own the stock. This can require a significant outlay of capital. For example, today the price of Apple (AAPL) is $267.25. And, if an investor wants to own Apple stock, he/she will need to put up $26,725.00. That’s a lot of money for 100 shares of stock. Granted there are many stocks out there that cost much less than Apple, but Apple is a highly liquid security, which is an important factor to keep in mind when buying ANY security.
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Instead of buying the stock outright and paying the full price for the shares, an option trader could put on a position that would have the same “bullish” bias as long stock. Let’s use (AAPL) again. If I believe Apple has a good chance of increasing in value, instead of buying the shares today, I could Buy the right to own (AAPL) for the next 60 days and pay a fraction of the current stock price.
To do this I could buy a call option at the 265 strike expiring on January 17, 2019 and pay a premium of $10.10 or $1010 for 1 contract (each contract represents 100 shares of the underlying). That is considerably less that $26,725. But, wait a minute, if I exercise my right to Buy the stock on or before expiration, I would still have to pay the $265. And that would be true. But you must remember that your CONTRACT has real value. And just as the stock price can rise, so too, can the value of the option.
Remember what an option contract lets you do. you have the right to buy the underlying at the strike price at any time up to the expiration date. Now, let’s say within a few days of purchase the price of AAPL explodes upward on the head of some news and rises to $275. Since you have the right to buy at $265, you could sell your $265 call option and pocket the profit less the price you paid for the option. You might be saying that you’d have been better off, if you had bought the stock outright. And in this case that would be true. But the POP for stocks is always 50/50. Instead of going up, the stock could have dropped $5. You’d be out $500. But, since you bought the option, the most you can lose is the $1 price you paid.
When you BUY an option, you pay a price (the premium) for the contract. This price is a function of perceived risk taken by the counter party, who, in this case, would be the Seller of the option. Earlier we said the contract has two sides; the buyer and the seller. Essentially, the buyer BUYS what the seller SELLS. Don’t think of this as a specific person standing around waiting for you to put in an order to buy an option. Today, all trades are placed electronically. But there is a seller selling.
If you, the buyer, want to buy, it is your belief that the underlying will go up in price and you will be able to sell it later at a profit. But remember, the seller is selling you the contract because he/she believes the price will go down and he/she will be able to buy it back for less than he received, when he sold it.
In the large world of options volume, the larger the volume of players the better the price will be for both parties concerned. It really comes down to supply and demand.
Simply stated, if there are more buyers than seller for a given supply of a product, the price must go up. And when there are more sellers than buyers for the product, the price must fall. Of course, there are many variables that go into options pricing, such as time, volatility, risk free interest rates and all that, but for now just keep supply and demand in mind.
