Why Trade Options?

The reason why options-in one form or another-have existed for so long has to do with the many benefits that options offer to both parties to the contract.

As the buyer of an option, you can acquire the right to something without owning it. In the case of the Olive Presses in the preceding article, the option buyer purchased the right to use the presses during the harvest season. The option buyer didn't own the presses. The option buyer didn't have to maintain the presses or store them. But the option buyer had what was important: the right to use the presses when it mattered, during the harvest season.

The ability to control the use of the presses is what gave the option contract its value. It can be assumed that the price paid for the option was less than what it would have cost to purchase, maintain and store the presses until the harvest. This allowed the option buyer to use leverage to control the use of the presses for less than the cost of owning them.

What was the risk to the option buyer?

The buyer risked the price paid for the option.

How so? If there was a poor olive harvest, the presses might be available for use without the need for the right to use them. In this case, the option buyer lost the price paid for that right.

On the other hand, what happened if a disaster wiped out the only other source of olive presses for the harvest? The right to use the press in this case would become much more valuable

We can state the above situation in another way.

The option buyer created the right to have large gains with a loss limited to the price paid for that right. Another way of saying it is this: the option buyer had the potential for unlimited gains with limited risk.

What did the option seller gain from this transaction?

The option seller obligated himself to allow the option buyer to use the presses during harvest time. The seller received a fee for this obligation. This fee created income during a period when there was no other income. The option seller gave up the possibility of receiving greater income during the harvest in exchange for income today.

So the net result was that the seller gave up some potential upside.

The same situations suggested in these example involving options on the use of olive presses are essentially the same sort of decisions that options buyers and sellers make in the financial markets everyday. Just substitute "stock" for olive presses—though you could also substitute bonds, futures or international currencies.

Let's summarize briefly. Again, the option buyer can use relatively small amounts of money and leverage to create potentially large gains. Additionally, the option buyer can limit the risk of loss to the price paid for the option.

On the other side of the trade, the holder of financial assets can be sell options to create income on these assets.

How some of these strategies can be implemented by traders looking to either buy or sell options will be discussed in the next article.

John Emery has been a professional trader for more than a decade, trading in stocks, options and stock indexes on a daily basis. A former proprietary trader, Emery has written numerous articles for TradingMarkets over the years on topics ranging from trading basics to his own trading methods and strategies. Emery uses options both to trade and as a risk reduction tool.

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