Strictly speaking, options are choices: the choice to buy, sell, or hold; the choice own or rent a home; the choice of what to eat for dinner. Having options means we have the ability to make – or not make – choices about our lives.
Financially, though, options have a very specific meaning. An option on a stock or bond is the right, but not the obligation, to buy or sell the security at a specified price up until a specified date. Call options are the right to buy a stock; put options are the right to sell a stock. Options are powerful investment vehicles. For a fraction of the price of a security, you can benefit from price movements in that security.
There are three main factors that go into an option’s price. The most important is the relationship of the “strike price” – the price where you have the right to buy or sell – and the current price of the security. For example, if you buy a call option on Apple stock with a strike price of 150 and its current price is 170, you would pay at least $20. That option is said to be “in the money.” Conversely, if the strike price is 200, that option is out of the money. You wouldn’t exercise it until Apple stock rose at least $30 higher.
The other crucial inputs that matter in option pricing are the time the option has until it expires, and the volatility of the underlying stock. In both cases, the more time the option has and the more volatile the stock price, the more the option will cost.
Options aren’t just financial jargon. There are options in everyday life on all kinds of things. Sometimes people lease a house or condominium with an option to buy. They don’t have to buy the house, but they have the opportunity to do so, usually for a year or so at a specified price. Movie studios will purchase the option to produce a film based on a best-selling book from the author. They don’t have to make the film, but they have that choice. Mortgage borrowers have the option to refinance their homes if interest rates fall.
Options are an important part of the markets and our lives. The more we understand them, the better we can understand and profit from the quirky nature of markets in all their various forms. We just need to be careful. As the Greek philosopher Aristotle once noted, the more we know, the more we realize we don’t know.
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