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What Are Stock Options?

Stock options (equity options) are very powerful financial derivatives that are traded around the world. A derivative is an instrument whose value is derived from the value of some underlying asset. In the case of stock options, the value comes from (among other things) the price of the underlying stock.

Options can be traded in at least two places. One is an options exchange (such as the Chicago Board Options Exchange, or CBOE). When an option is traded on an exchange, you can easily get a quote on its market price at any time during the day. When you call your broker or go on-line to check the price of an option, you are being quoted a price for an exchange listed option.

Another place where options are traded is over the counter (OTC). This is slightly different from OTC stocks, because prices for OTC stocks can actually be quoted from most brokers and finance websites. In contrast, an OTC option need not be standard; therefore its price can be unique and is generally only quoted by the financial institution that sold you the option in the first place. As a result, liquidity for OTC options can be a problem. When things go wrong you could lose your shirt (and your shoes, your house, your car, your spouse, etc.). Such options are usually reserved for institutions, for reasons too numerous and boring to mention here.

When the market is open, the price will be synchronous with the underlying asset (i.e., when the stock moves, the option’s price changes to reflect the new state of the world). When the market is closed, options prices are more than useless, since some stocks can be traded after hours and no one on the floor will be making prices for the associated options.

The pricing of exchange listed options is achieved through some magical voodoo formulas that no one believes to be accurate, but cannot disprove because the market claims the value is what the price says. Therefore if the market clearing price is listed on the exchange that is the value of the option, irrespective of whether or not that is the true value of the option relative to its characteristics (such as volatility, time to expiration, risk profile of the underlying asset). The last point is actually what makes options so fun.


Uses of Options

Stock options have two primary uses: insurance and speculation. To understand how options are like insurance, consider the following example. Let's say you buy a brand new car. In most states, car insurance is legally required before you are allowed to drive it around. Thus, in addition to the car, you have to buy the insurance, and pay the premiums on it.

The price you pay for an option is akin to the insurance premium. Now, assume you total your car. If you have insurance, you simply call your agent, and the company will give you the cash value of your car. In terms of stocks, if the price of the stock tanks, you can simply exercise a put option on the stock, and sell it to someone at a pre-specified (presumably higher) price. As such, you are protected. The option has given you an insurance policy on the volatility of the underlying stock.

Using options as a tool for stock speculation is even more intuitive. Let's say you think stock XYZ will rise a lot in the next few months. You want to buy some shares, but you don't have the money right now. To act on your hunch, you can buy options on XYZ stock (assuming there are any being traded). In so doing, you will use far less money than if you went and bought the stock directly. Now that you own the options, you have the right to exercise them if the stock does well, and you lose all your money if it does poorly. If it does well, your return on investment is much higher than if you had purchased just the stock. If it does poorly, you will have lost far less many that owning the stock outright.


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