Options FAQ, Part 1: What art thou?

Recently, a reader asked for more discussion of what an option is, how to trade it, and how it has value. As an short-term options trader, what I present here is not necessarily how I make money, but rather, what the option product is typically used for.

Part 1: What are thou?
What is an option? To pull a cliche, I will quote from a dictionary (Wikipedia):

"Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security."

What does that actually mean? In high finance, every contract involving money is a "financial instrument". It merely means money is involved. A security is kind of contract or product that is traded for money.

So essentially, Options are financial contracts that give the right, but not the obligation, to trade a product for money. An options primary purpose was to hedge a bet. We'll get to that soon.

Options have 4 fundamental characteristics:

1. type of option
2. strike price of option
3. expiration date of option
4. underlying security (asset).

First, let's choose an underlying security, for instance, Google stock (GOOG).

Next, let's choose an option type. There are two, calls and puts. Calls give the option to buy. Puts give the option to sell.

But at what price can we choose to buy/sell? That's the strike price.

Finally, option contracts have expiration dates, typically at most 12 months as a time.

Now that you know the basics, how can you use it to hedge your stock portfolio?

Say you own 100 shares of Google at today's close price of $715.26. You're fairly certain that in the next month, Google stock will rise, but you want to guarantee that you get at least $700 for your stock.

What do you do?

You can buy one (1) Jan '08 $700 Strike Price, Google Put (typically, options are traded in 100 contract blocks, so buying one = 100 contracts). The current price of each contract is $22.80, which makes this put option worth $2,280. Let's look at a graph to see how this can be useful:

The x-axis is the value of Google stock, and the y-axis is the value of each stock in your portfolio.

The blue line represents ownership of the stock. The value of the stock to you increases and decreases in a 1 to 1 ratio with the actual stock.

Now, with a put option, indicated by the red line, the value of each stock can not drop below $700 a share, because if it does, you can exercise the contract, and sell your shares at the strike price. In effect, buying the put option has guaranteed you a floor, or at least, $700 / share.

Is spending $2,280 worth locking in at least $70,000? It depends entirely on what you believe is the chance that Google stock will decline, as well as how much money you want to make on this trade. A simple way of thinking about it, is that the money is spent to insure your asset.

For now, this is a very basic introduction to the classic use of options to hedge a portfolio. The next part will focus on more advanced hedge functions.