Around 600 B.C. there was a Greek named Thales. Like many other Greeks, Thales liked to think about how the world worked. Olives were a big commodity back then, and they still are today. During those times, olives were used for everything from cooking, soap, lamp oil and even as a skin softener. For several seasons around that time he wondered why the olives weren't blossoming, which was sending many citizens and farmers into distress.
He studied how olives went from the trees to olive presses and tried to predict when the harvest would come once again. He was more of a mathematician than a philosopher, and by tracing previous weather patterns and examining the stars above he was confident that the olives would grow abundantly in the coming year. An astute businessman for his time, Thales cut a deal with many of the farmers, buying the "right" to use their olive presses within a given period of time in exchange for a nominal fee. The farmers, skeptical that the olives would never come again, largely accepted his offer because they figured that getting some profit, no matter how small, was better than getting nothing at all. If the olives never came, Thales would have no use for the presses but they would get to keep the fee he gave them regardless.
Alas, the olives came!! With the agreements with Thales intact, the farmers could not cash in, since Thales was the one with the rights to use the presses. He had essentially cornered the olive market by purchasing the "option" to take control of virtually all the olive presses in the region. Legend says that he never exercised these options and let the farmers slide, partly because he had no time to get involved in the olive business. In any case, this is believed to be one of the very first options trade on record.
Modern-Day Options
Options have been around since the 1970s and are offered primarily on the Chicago Board Options Exchange.
The Options Industry Council defines an option as "a contract to buy or sell a specific financial product officially known as the option's underlying instrument or underlying interest." You may have worked for a company that offers you stock options in lieu of some salary or compensation, allowing you to purchase shares of the company stock after a specified period of time and at a specific price, even if that price is lower than the current market value. These are more or less the same options as those offered in the market.
Let's try an example... Suppose I have a cell phone valued at $100, and let's pretend for the moment that it's a share of stock, fluctuating along with the market. In exchange for $5, I'm going to give you the option to buy the cell phone from me for $100 within the next 60 days. Now, what if the value of the cell phone reaches $150 within 20 days, should you buy it from me for $100? The answer is yes, since you could take the phone and resell it to the market for $150, and your profit would be $45 ($150 - $100 - $5 = $45). What if it hits $50, should you buy it then for $100? No, since you'd be losing money if you resold to the market at $50. Then your loss would only be $5, the price of the option contract. After 60 days, the contract has expired and it would be worth nothing, so you'd only lose $5.
The above example is called a "call," meaning the right to buy. A "put" by contrast, is the right to sell. A put is not the same as shorting a stock, for you stock traders familiar with the technique. This is because you are not borrowing shares, just buying contracts to have the right to sell. There are many other trading techniques other than calls and puts, but this site is intended to keep things simple, so it will only concentrate on these two methods. Moreover, there are other kinds of options out there, such as those offered on commodities or on the forex market, but again, we'll stick to stock options.
Now, do you actually have to exercise the right an option gives you in order to make money? The answer is no, because the actual value of the option will change along with the stock price. In the example given, the $5 option would increase significantly in value if the stock reached $150. You can actually resell that $5 option to the market. As a ballpark figure, it would probably be worth $45 in this case, a huge percentage profit on your part. With puts, the same holds true. In fact, how could you buy the right to sell a stock at a specific price if you don't even own shares in the first place? This is because you're only trading the right to sell itself, not necessarily exercising the right to sell.
Should you actually exercise options, instead of just trading them? The answer is yes, but for the sake of simplicity we'll concentrate more on trading them. The section below "Options as a Hedge" provides information on using puts effectively if you're already a shareholder.
Options as a Hedge
During the dot-com era many stocks rose to unthinkable limits, only to come plumetting down in time. Many investors and Silicon Valley employees made millions, only to come back down to earth. Many got greedy, refusing to sell their stock. Should they have sold early enough, they may have kept their Ferraris and million dollar homes in the process. The truth is, options could have kept them wealthy, even after the dot-com bust.
Let's say tech stock XYZ was at around $350 dollars, which wasn't uncommon for some shares back then. Let's also say that there's a put option on that stock that you could've bought for $5, giving you the right to sell the stock for $340 within say, the next 730 days. Now, poof, the bubble bursts, and XYZ's price starts to slowly slide. It's passes $340, then $300, then $200, and then... $10!! Again, not uncommon in those days.
Let's say tech stock XYZ was at around $350 dollars, which wasn't uncommon for some shares back then. Let's also say that there's a put option on that stock that you could've bought for $5, giving you the right to sell the stock for $340 within say, the next 730 days. Now, poof, the bubble bursts, and XYZ's price starts to slowly slide. It's passes $340, then $300, then $200, and then... $10!! Again, not uncommon in those days.
If it was at $10 and you had been smart enough to invest in a $5 put option for every share that you owned, then guess what??!! You could've sold your shares at $340 a piece (assuming it's within the 730 days), despite the horrific market price of the stock at the time of your sale!! Think about it, just $5 per share would've saved many people's fortunes. This is an effective way to use options as a hedge if you already own shares. You can exercise the options, of course, but it's also a good way to protect your financial assets.
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