Let's say you think very
highly of Company ABCD, and you're convinced that
the stock price will go up from its current trading
price of $50 per share. You could do two things. You could either just
buy the stock for $50, and hope that the price goes up. Or-- and I made this price
up-- you could go to an options exchange and for
the price of $5, you could buy the option to buy
this stock over the next month. It expires in one month. Usually it will be
a specific date, but I'm just saying
one month from the date that you buy the option. And it gives you the option to
buy the stock for $60 a share. The type of option that
I've just described is called an American option. And it can be compared
to a European option. An American option allows
you to exercise the option-- to actually buy the
stock-- any time from the time you have the
option until the expiration. On a European option, you
only have the option-- you could only exercise
it-- on the expiration. But we'll just focus
on the American. Now let's think about
the different outcomes depending on what
the stock does. So let's say the stock actually
does do what you think it does. Let's say it goes up,
and then it goes down. Let's say that you're really
good at calling stock price tops. And then right over here--
let's take the two scenarios. Let's take the scenario
where you bought the stock, and then you sell the stock. So you bought at $50
and then over here right at the top-- you're just a
perfect market caller-- you were able to sell
the stock at $80. So let's just think about the
different profit scenarios. So here we have an end
price of $80 per share. If you had bought the stock for
$50, and now sold it at $80, you will have a profit of $30. Now let's think about if
instead of buying the stock, you bought the option today. So if you bought the
option, same thing. When the stock goes
up to here, you'll say, oh, I think that's
the top for the stock. Let me exercise my option. So I'm going to exercise
my option, which gives me the right to buy the
stock at $60 a share. So you're going to buy it at
$60 a share, right over here. And then you can immediately
sell it for $80 a share. So you can make $20
on that transaction. But of course, you paid
$5 for the option itself. So you make $20 on the
difference between 80 and 60, but you had to pay 5. So you have a $15 profit. So there it says, hey, look. Maybe I was better
off buying the stock. And even there I would say,
look, to buy the stock, you had to put $50
of capital at risk. To buy the option, you only had
to put $5 of capital at risk. And to see that, imagine
the negative scenario, where instead of the stock doing
that, let's say the stock just completely plummets
after you buy it. And it goes all the
way down to $20. Now in the situation
with the stock-- let's say right over
there you just had enough. You just say, I want
to sell the stock. So this is an end price of $20. In that situation, you
bought for $50, sell for $20. You will lose $30. But in the option
scenario, this entire time that it was
plummeting, you'll say, I just won't
exercise the option. The option is out of the money. It makes no sense for
me to exercise it. So you just won't
exercise the option. So you'll only lose the price
that you paid for the option. You'll only lose your $5.