Fundamentals of Options

Check out my explanation of the basics of options…


In this video we are going to talk about the fundamentals of options. Now when most people talk about options, they think about trading stock options. I’m actually going to talk about options in a broader context, because there is a valuable theoretical idea going on here. Options are actually something you come across in business all the time, and if you understand the concept behind options, it can be very powerful.

So what is an option? An option is a financial contract giving the holder the “right” to buy or sell something at a specific price by a specific date in the future. So when we talk about a stock option, we are talking about purchasing the option to buy or sell stock at some point in the future. So we are not actually buying the stock, we are buying the right to buy the stock.

So here is the fundamental question. How do you value the right to buy something? We are not actually purchasing something. We know how to value that. We would look at supply and demand in the market and determine an appropriate price. But we are not actually buying. We just have the right to buy. The right is valuable, but how much? It would clearly be less than the actual purchase, but how much less?

This concept is what the study of options is all about. Understanding how to value the option to make a transaction. So if we take a step back from the stock market, this is a fundamental question you run across in business all the time. You might have a contract with an option to purchase land. It’s not actually buying the land, it’s the option to buy the land. You might have an option to extend a service contract. It’s not actually forming a contract, but the right to enter into a contract.

So when you look at the larger scale, what we see is this is a financial derivative contract used to manage risk. If you have an option contract, you are delaying the decision to make a transaction until you have more information. For instance, if you sign a one year service contract, with an option to extend a year. You are delaying that purchase of the second year. This reduces your risk, because you don’t have to commit. Now the cost of the option is going to be built into the cost of the contract in the first year, but it may be worth it. So by splitting up your business decisions into several options over time, rather than purchases up front, you can better manage uncertainty about the future, while more effectively utilizing your capital.

This is also the same way insurance works. You pay a small amount every month, for the right to receive a payout in the event some specific event happens in the future. Think about your car insurance. Imagine if you had to put down the full dollar amount of a car accident up front. So you would not only have to pay for your car, you would have to put in a bank account the replacement value of your car, and the replacement value of someone else’s car. None of us would be able to afford cars. By paying a small amount for the option to receive a payout, it distributes risk across society.

So let’s bring this back to stock options. So you can purchase an option, for the right to buy or sell stock in the future. This allows you to pay a small amount up front, without actually spending all the money on the transaction. This allows you to delay the decision to actually buy the stock. Now we are still left with the small issue of how to actually value the option. In the next video, I’m going to talk about the Black Scholes Pricing Model, and explain how it values options.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.

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