A brief explanation of options
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Some notes on "A brief explanation of options" :-)

Written by Frank Malcolm and Paul Edwards
Released to the Public Domain

The information in here is not guaranteed to be correct.
Feel free to update.


INTRODUCTION
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There are two different sorts of options - call options and put options.
A call option gives the *buyer* (also known as the "taker") the right
(but not the obligation) to buy the underlying physical (in this
treatise I guess we're talking about shares as the physical) at the
specified "exercise" or "strike" price.

A put option gives the buyer the right but not the obligation to sell
the underlying shares at the specified strike price.

In both cases the option buyer "puts up the money" and the seller
receives it - but will have to pay margin calls or lodge shares as
collateral.

Conversely, the *seller* (also known as the "writer") of a call
option has the obligation (but not the right) to sell the underlying
shares at the strike price, and of course the seller of a put option has
the obligation but not the right to buy the underlying shares. The
process whereby the buyer of the option requires the underlying shares
to be bought from or sold to him is called "exercising" his option.

You also have different possibilities for exercising - American or
European. American exercise options can be exercised at any time up to
and including the expiry date; European options only in some defined
period(s), possibly only on the expiry date. Exchange traded options in
Australia are all American, "company" options (listed along with shares
by ASX) can be American or European.

In brief:
Buying a call option gives you exposure to upward movement in the share
price, with the downside limited to the premium you paid. You pay the
value of the premium to the seller.

Buying a put option allows you to profit from a downward movement in the
share price, with the downside (if the share price goes up) once again
limited to the premium. You pay the value of the premium to the seller.

Selling a call option gives you the premium cash in hand, but with
*unlimited* exposure to an upward movement of the share price. You
receive the value of the premium from the buyer, but need to lodge cash
or shares as collateral.

Selling a put option once again gives you the premium in hand, with your
exposure being the amount of the exercise price (if the share price
falls to zero). You receive the value of the premium from the buyer, but
need to lodge cash or shares as collateral.

The most common option transaction by the general public (GP) tends
to be buying a call option. Of course there must be a seller, 
but that is usually the dealer. Second most common (by the GP) 
is probably buying a put or selling a call; least common,
probably even less than some of the simpler combination strategies,
might be selling a put.

When you buy a call or a put you must pay for it, with money. When you
sell a call or a put you will receive money for it, but will be required
to pay margin calls. A margin call can be paid in cash, and you receive
this back when you close the position, if the share price hasn't moved
against you. You are paid interest on that money. Alternatively, you can
lodge shares as collateral for your "short" position.

A margin call for which you pay cash is likely to significantly exceed
the $ you received for selling the option. Of course, the margins are
"marked to market" daily, so if the share price moves quickly in your
favour, you'll soon get a lot of it back. (And if it goes the other way,
you'll have to pay more! :-))

Option pricing in fact has very little to do with market sentiment,
except insofar as that sentiment is reflected in the price of the
underlying share. What it *does* depend on is the price of the share,
the exercise price of the option, the time to expiry, expected interest
rates over that time, and the expected "volatility" of the share over
that time. And of course, supply and demand.



SCENARIO 1
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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 BY A SMALL AMOUNT.  You run the risk of missing out
on possible gains.

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 exposure to 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.

This is an example of selling a call option.  The payoff for that 
is that if the share price remains below the exercise price ($9), 
you "pocket the $1". If the share price exceeds the exercise price, 
you will keep less and less of your $1 until $10, when you lose 
the lot. Above $10 you are losing cent-for-cent for every cent 
the share price rises.

Actually, it's more complicated. The scenario actually described being
long (owning) a BHP share *and* selling a call. That's equivalent to
selling a put naked (without owning the stock) and the payoff from the

[Say what? - Ed]

total position is that you "pocket the $1" (the premium) if the share
price remains *above* the exercise price, and lose cent-for-cent if it
falls below.

If indeed "you are more concerned about your stock dropping than you
are about missing out on possible gains", you should buy a put option.
If the share price goes down your loss is limited to approximately the
value of the premium, whereas you still participate in any gains. (But
to a lesser extent - the value of the premium - than if you just owned
the share.) This strategy is called a "protective put".

Another comment - the buyer doesn't actually "get into BHP" for $1 
(he'd also have to pay the $9 exercise price if he wanted to do that), 
but he is positively exposed to BHP's share price for the period the 
option has to run, for just $1.


SCENARIO 2
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You have the same BHP share.  You think your share will be worth
$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.

This is another example of selling a call, except this is one
where there is a higher exercise price, so it costs a lot less
to buy.


SCENARIO 3
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You are extremely worried about BHP, and fear that it may go
bankrupt.  You don't care if you have it wrong, and it's about
to boom.  It's currently at $10.  You buy a put, with an
exercise price of $10.  You might actually have to pay $1 for
this put.  But after a month, if your stock is worth $0.05, it
doesn't actually matter, because you have a RIGHT to sell your
share for $10!  The other guy has to fork over the money, that's
why they had to put up security.  The hope that the other guy
had was that the share price would remain above $10, and thus
he would have ended up pocketing your $1.


SCENARIO 4
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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. 

What you actually do if you think BHP is volatile, ie you think that in
the next month (say) the price will be anywhere *except* where it is now
(approximately), is take a "straddle" position - you buy a call and a
put at the same exercise price. You make money if the share price ends
up a long way in either direction from where it is; you lose the most if
it stays exactly at the exercise price, and you lose a little bit if it
is a few cents (maybe 10s of cents, depending on the actual numbers)
either side.

This assumes you *don't* own the stock. If you do, you can achieve the
same effect by selling your share, and buying 2 call options. This is
called a "reverse ratio".

[Que?  If you sell your share, you will be back in the position of
not owning the stock!  - Ed]

As far as I'm aware, these scenarios cover all the common 
buy/sell options.

However I should probably concentrate on getting a clear understanding 
of the "naked" positions first - buying and selling a call, buying 
and selling a put. And, because they become part of the more complex 
strategies, also consider the (straightforward) payoffs from buying 
(or holding) the underlying share and selling (possibly short) the 
underlying share.

However, I don't know what all that entails.

There are a large number of well-known combination strategies, with
colourful names such as "long condor", "put ratio backspread",
"short strip", etc.
@EOT:

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