Uses of Options

Below is an illustration of the most obvious use of options. There are many uses of options but most people use options as illustrated below.

Consider a $50 3 month call option on a stock with current market value of $49 and a premium of $2.

The premium is the value of the option and the $50 is the strike price of the call option. Since the strike price of the call option is $50 which is more than the market value of the underlying stock which is $49, the call option is out of the money.

If the stock price falls, the option owner will not exercise

If the stock's market value falls to, say $40, the call option buyer will not exercise the right to buy because he or she can buy it cheaper on the market than the price he or she would get by exercising the option.

If the stock price rises, the option owner will exercise

If the stock price rises to say $60, then the option buyer will exercise at $50 and make $8 which is the difference between the market value and the cost of the option and the underlying stock.

The more the stock price rises the higher the profit. Therefore, the call option limits the downside while allowing the investor to benefit from most of the upside. This is the most basic use of options and options trading. Options is also used in hedging to limit the downside.

For the holder of a put option, a similar case can be illustrated. If the stock rises, then the owner of the put option will not want to exercise his put option (the right to sell) because it is better to sell on the market. However, if the stock price falls below $50, the put option allows him or her to sell the stock at the $50 price. If the stock price falls to $2, he or she can still sell at $50. For a relatively low initial cost, the investor can limit his or her downside and still reap the benefits of the upsides.