Options 101

Options FAQ (Frequently Asked Questions)

Q: What is an option?
A: It is the right to 'opt' to do something.  Fundamentally, there is
no difference between a "end-of-lease-buyout option" and an option in
the financial markets.

In financial markets, an option represents the right to buy or sell an
asset (shares of stock, bonds, pork bellies) at a particular "strike"
price (and yes, it does relate to baseball), at a particular time (say,
3 p.m. on the third Friday of the month), at a particular place.

There are two essential types of options: a "Call" is the right to BUY
something, while a "Put" is the right to sell something.
 

Q: So what's the big deal about options?
A: In a word: leverage.  By buying a single option contract, you
control 100 shares of stock.  Depending on the strike price and the
time left in an option, small movements in the underlying stock can
lead to large movements in option prices.
 

Q: So why would I pay someone for the right to sell them something?
A: Let's start with a type of insurance called a "Protective Put".
Let's say you think a stock you hold is vulnerable to a large decline,
but you don't want to sell the stock.  Instead, you buy a Put at about
the current price.  If the price declines, you have the right to sell
the stock at the higher price; if the price doesn't decline, you let
the option expire.

This type of option was used in the USA by farmers who wanted to
lock-in a price for their produce without having to guarantee delivery.
 

Q: I'm new at all this, and I just want to have some fun ... should I
play with options?
A: Only if your favorite sport is playing Russian Roulette.  DO NOT
USE OPTIONS UNLESS YOU KNOW WHAT YOU ARE DOING.
PEOPLE FAR SMARTER THAN YOURSELF HAVE LOST MORE
MONEY THAN YOU WILL EVER SEE IN YOUR LIFETIME AT
THIS.

Have I made my opinion perfectly clear?

I would recommend taking a course in options, or at minimum reading
several books on the subject, and then testing yourself using 'paper
trades'.  You can lose a lot of money if you don't know what you're
doing (just ask someone who wrote naked puts in October 1987).