Investors are usually bewildered by the mechanics of stock options basics when they begin to learn about them. While options as an investment are less straightforward than ordinary share or mutual fund purchases, there’s no reason why getting stock options explained adequately to you has to be particularly painful.
At their root stock options provide a way to assume leverage on a potential movement in the price of a stock about which one feels strongly, without having to put up the entire amount of money that would normally be required to execute the trade. At the same time options offer a method for a person looking to hedge an existing stock position in case of a market move against them.
As the motivations for each of these two trades are diametrically opposed, we can see how the seller of the option contract provides the option buyer with the means to make a quick profit if the price of the stock rises abruptly. The seller will be forced to deliver his shares to the buyer (who purchased the ‘option’ to buy them at a given price point on a given date in the future) should the underlying stock makes the upward move the option buyer is expecting. The buyer pays a relatively small amout of money for this right, which is why you hear stories about people making huge profits very quickly with options.
In turn, the option seller receives this small amount of money from the buyer, which constitutes a hedge against the downward move he fears. Insurance like this can be quite appropriate if a stock or the general market has recently had a quick move upward.
This brief explanation should show why options basics don’t have to be a big mystery, and why even new investors might be interested in using them, especially on the sell-side if they have an existing portfolio. Buying options is a very different matter, however.