An option is a contract that gives you the right to buy or sell an asset for a specified time at a specified price.

This asset can be a "real" asset such as real estate, agricultural products, or natural resources, or it can be a "financial" asset such as a stock, bond, stock index, foreign currency, or  futures contract.

Why would you want to trade options?  The short answer is that options allow you to bet on future events and to reduce the financial risk you face.

As an illustration, suppose an entrepreneur comes to you and asks for $45,000 to invest in a project.  After studying the situation, you estimate that the project is equally likely to succeed or fail after three months.  If it succeeds, you will get back $100,000; if it fails, you will lose your entire investment.  Thus, you have the opportunity to invest $45,000 in an investment project that pays $100,000 with probability 0.5, and $0 with probability 0.5 in three months time.

Suppose your investment advisor recommends that you decline this opportunity, saying that it is too risky.  Meanwhile, a friend draws your attention to a second entrepreneur who is trading options on this project.  These particular options are put options.  Each contract costs $26,000, and if you buy one, it gives you the right to sell the project at the end of three months for $50,000.  What is neat about this option is that you can sell the investment (i.e., exercise the option) for $50,000 whether the project fails or not.  You quickly calculate that you would not want to exercise the option if the project succeeded, since the project is worth $100,000, but you would surely do so if it failed!  Therefore, the option pays $50,000 if the project fails and is worth zero if it succeeds.

Is this additional information relevant?

Yes, it is, because if you buy two options ($52,000) and invest in the first project ($45,000), you have an outlay of $97,000, but you are guaranteed to receive $100,000 (i.e., $100,000 if successful and 2x$50,000 if it fails) in three months, which is a greater than 12% annual return. 

The options have eliminated all the risk that was worrying your investment advisor.  Now, all you have to think about is whether the sure return can be beaten.  Essentially, by buying the option, you have transferred your risk to the entrepreneur selling you the options.

You can use options both for betting on events and for hedging (or reducing) risk.  You could buy one of the options by itself and bet on the project failing, or you could both buy options and invest in the project to eliminate all risk.  You can have a partially hedged position:  Invest in the project and buy only one option.  Or you could really take a gamble, and invest in the project and sell some options!

To summarize, the central reason to trade options is that they allow you to place bets on events and also allow risk to be managed.

There is another application of options.  On October 19, 1987, Black Monday, the US stock market had its worst day in history.  The Dow Jones Industrials Average fell 508 points, or lost 22.6% of its value, on that day.

Suppose that before Black Monday, you had acquired some December put options on the index, providing you with the right to receive the value of the index at a fixed price over its life.  Then, on Black Monday, while the stock market fell in value, your put options would have moved in the opposite direction and become quite valuable.  On the other hand, if you had bought call options, which allow you to sell the value of the index at a fixed price, then your calls would have become worthless.

If you had a stock portfolio, the put options would have protected your losses.  In fact, if you had enough puts, you might even have made a fortune that day.  Of course, the person selling you these options would have lost money.

Again, the put option serves two purposes.  First, it allows you to limit the downside risk of your stock position, and second, it lets you bet on a fall in the market.   In fact, if you have reliable information that leads you to believe there might be a major market correction, an option would provide you with an easy way to bet on the basis of your information.

This last point applies more generally.  For example, suppose that on October 1, 1989, an investor had concluded that market volatility was likely to increase sharply, but the investor could not predict whether the market was either going to jump higher or lower.   While volatility information does not translate easily into a stock trading strategy, the investor could have used the option markets to create a profitable trading strategy.  One such strategy is to buy both put and call "at-the-money" options (i.e.,  set the fixed delivery price equal to the current value of the market index).  Now, the investor makes money no matter which way the market moves and only loses if the market is stable.    In fact, the farther the market moves either below or above its current value, the more valuable this investor's position becomes.  Of course, the profitability of this strategy depends on what the investor pays for the options.

In the subject Option Payoffs in Options Tutor, you can use the option prices in the software, or enter your own option prices, to see what happens when you take different positions in put and call options.  This exercise should give you a feel for how you might use options.  For example, what types of positions would you construct if you expected a lot of volatility?  What if you expected a stable market?  What if you expected the market to rise, but wanted to limit your losses in case you were wrong?

In this chapter, we start by introducing you to the contractual details associated with options.  In DefinitionsDEF_OPT, topic 1.2, we tell you what an option is and how payoffs are defined.  In topic 1.3, Options and Organized ExchangesOOE_OPT, we introduce some of the important institutional details about option contracts.  Then, in topic 1.4, Options:  An Online ApplicationOPA_OPT we provide a real-world example you can use in conjunction with Option Tutor’s Option Payoff subject.  Finally, in topic 1.5, Option Valuation:  An OverviewOV_OPT we provide an overview of how we describe option pricing theory in this book.