Posted August 15, 2023

There are three reasons to buy or sell an option that depend on your expectation for the stock price.

1. You wish to exercise the option, either to buy or sell shares of stock.
2. You buy an option because you speculate that the option will become more valuable and hope to sell it for a profit.
3. You sell an option because you anticipate that it will expire worthless and thus pocket the premium, or that you may buy it back at a lower cost. By selling high, then buying low you close the position and terminate the obligation, and, in the process, you net the difference.

The option’s value may rise or fall because the price of the stock may change before the option contract expires. The option value will thus rise or fall as the option derives its value on the underlying stock. Thus, the option derives its value on the underlying stock. These contracts may be traded, just like the stocks are traded.

Why do people buy options? According to the Chicago Board of Options Exchange, only 10% of options are exercised, or converted into a transaction on the actual shares of stock. Roughly 65% of options are closed, and the rest, 25% of option contracts expire worthless.

Ok great, but why do people buy potions? If we dive more deeply into the stats above, only one in ten folks who buy options exercises the option to buy a stock (or sell) a stock. Let’s look at the option to buy a stock, the call option. It would be a great deal if you had the Call to buy 100 shares of XYZ stock at $25 a share if the stock was trading at $50 per share. If you exercised your right, the person who sold you that Call would need to provide you 100 shares of XYZ at $25 per share, $2,500. You could immediately sell the shares on the open market for a nice profit! Though you’d be happy in this situation, the call seller is not! As you have “called” the shares away, they would need to fork over 100 shares of the stock from their portfolio to cover the obligation. If they did not have the shares to cover the obligation, they would need to go out to the market, buy the shares at the $50 market price, and then deliver them to you at $25 per share. The call seller would realize a loss of $2,500.

The moral of this story is its always best to have some cover, do not be naked!

Coming soon… “Let me put it to you this way… the other option.”