A brief explanation of options
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Written by Paul Edwards
Released to the Public Domain


Note - this documents my understanding of options, because
I lost my brochure that explained it, so I thought I would
take a guess at it, and then ask for corrections.
Corrections please!


Ok, there are two different sorts of options, put options
and get options.  Put is when you put up shares as security,
Get is when you put up money.

Scenario 1:

You have 1 share in BHP.  BHP is currently worth $10.  You
go to the options broking house and say "I will sell you
1 BHP share for $9 in 1 months time, how much will you
give me for me letting you have this OPTION of BUYING 1 BHP
share for this price?".  Now let's say the market thinks
that BHP is going to stay rock-solid for the next month.
Well, they will give you $1 for that option.  You put up
your share as security, and you pocket the $1.  If after
1 month the stock falls to $8.99, the person won't be 
interested in buying the stock for $9, and so you get $1
profit, which helps make you not feel so bad about your
BHP share falling in value.  Because in actual fact, you
will have lost just 1c.  If the stock was still worth $10
at the end of the 1 month, then the person will indeed be
interested in buying your stock, so you will have broken
even.  If the stock was worth $11 after a month, then 
you've just missed $1 worth of gain, because the other guy
will get that gain instead, when he buys your stock for
just $9 (or you buy the right off him for $2).  Basically,
this allows you to buy insurance against your stock dropping
in value.  If you are more concerned about your stock 
dropping than you are about missing out on possible gains,
then this is the way to go.  From the other guys perspective,
he is paying $1, which would actually DOUBLE in value if the
stock went from $10 to $11.  To have bought the share, and
then sell it after a month, would have cost him $10.  This
way he gets into BHP for just $1.  He takes the risk of the
share being worth $10 or less at the end of the month,
meaning he loses his $1 completely.


Scenario 2:

You have the same BHP share.  This time you want to sell
the share for $11 in 1 months time.  The market doesn't
think BHP is going to go up.  But there is a small chance
it will, and in fact, there is a small chance it could even
be worth $12 after 1 month.  Someone is likely to pay you
2c for that OPTION to BUY.  If the price goes up to $12,
they stand to make 98c, a massive profit.  If the price
stays below $11, they will lose their 2c.  Basically, you
are hoping to make 2c for slightly risking your share, whilst 
they are hoping to make a 4900% profit by taking a much
larger risk.  For just 2c, someone gets the profit of a $10
share rocketting to $12, ie a massive gearing.


Scenario 3:

If you think BHP is extremely volatile, and will either go
below $9 in the next month, or go above $11, what you can
do is combine the two, and put up your shares, plus some
money, to cover both angles.  I'll have to think about that
one.


Anyway, as far as I'm aware, these scenarios cover all the
common buy/sell options. 
@EOT:

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