Wednesday, January 02, 2008

What are financial "options" and why do I care?

If you take a second level finance course in college you're probably going to run across discussing financial options. And if you're like me, you're going to be flustered, to say the least.

There are a myriad of sites and books on options. They are all full of confusing information. But you've got to struggle through them as they are actually quite important. Now that I've scared you, let me take a shot at explaining finance options and why you should care about them.

There are two types, call and put and they are related to a stock. Morningstar has a number of Google call and put options you can buy and sell just like stock. Today we'll just be discussing buying as it's much similar to understand. If I get time in the future I'll discuss selling, but to be honest, once you understanding buying you might be able to figure out selling on your own.

If you buy a call option (again just like stock) you have the right to buy stock at the option's exercise price. For example, let's say you buy a call option with an exercise price of $10. When the call option expires (i.e. when you get buy it), you have the right to buy the stock at $10. If the stock is currently trading at $15, then you exercise the call option (i.e. you buy the stock for $10) and make $5. If the stock is currently trading at $5, then you don't exercise the option (i.e. you don’t buy the stock for $10) and you simply walk away. Easy right!

Now let's switch to puts. If you buy a put, you have the right to sell the stock at the option's exercise price. Let's stick with our $10 option. If the stock is worth $5, then you'd exercise the options and sell your stock for $10. You're in the money and just made $5! However, if the stock is worth $15, then you don't want to sell it for $10 as you'd be losing money. The stock is worth $15 on the market!

Basically it comes down to this: If you think the stock is going to go up, buy a call. If you think the stock is going to go down, buy a put.

So why do we have options and what can they do for us? Honestly, to the average investor, they don't do anything for us. However, indirectly they help us as our investments (e.g. mutual funds) use them all the time. One example is to hedge a stock to protect it from losing too much value. Or worst, all it's value.

Let's say you buy a stock for $10. Because you have a mob of angry investors that have trusted you with their money, you can't afford to have the stock go under $5. If it does, they loose their retirement and you lose your job. So what do you do? You buy a put option that allows you to sell the stock at $5 no matter how low it goes. For example, if the stock goes to $0, you can still sell it for $5. Buying the put is simply insurance on the stock.

I hope these two simple call and put options help you get started understanding this arcane subject. If your ebullient curiosity is asking for more, Yahoo has a nice site for learning more about options. Enjoy!


Scooter said...

Plays into the market definitions for bull versus bear, yes? One is generally a put market. The other is generally a call market?

Mac Noland said...

Yep, I think you could make that analogy.

If you're wondering, when the market is bearish, you'll want to buy puts. That is, you get to sell your option at a price above what the market price is.

And when the market is bullish, you'll want to play the call so you get to buy an option below market value.

Though most of us would never do this as it's risky and complicated. We're much more comfortable buying mutual funds and our employeer's stock.