The Horse Race
The following analogy gives you a mind-set for options trading. Picture a horse race in which you place your bet. The value of your bet depends on the odds. If your horse is a 2-1 favorite, your chances of winning are high but you won't make much money. If the horse you pick is 100-1, your chances of winning are remote but if you do win the payout will be huge.
So you go to the horse race and you bet on your favorite horse, SeeBo, who is rated at 100-1, to win. The race is four laps, and as it begins you wait to see whether you will win or lose at the end. Pretty straightforward so far.
Now add a twist to make this race more interesting. You can buy or sell your bet during the race. If you are the kind of person who just likes to wait until the end of the race, then this twist changes nothing. If you are the kind who likes to take advantage of a positive development or if you are risk averse, this new dynamic changes everything, making it literally a whole new horse race.
Run through the possibilities to get a better picture of the complexities this twist adds.
After the first lap, SeeBo, surprisingly, is in the lead. You hold a bet in your hand that could be worth a fortune if SeeBo keeps this up and wins the race. What do you do? Do you sell it now? There are still three laps to go, so you won't get as much for your bet now as you would in the end—but is a little profit better than nothing? You decide to hold on.
In the second lap SeeBo fades and starts to fall behind. You regret not selling the bet when you had a chance, but still, if you sell it now you might get some of your money back. Instead you decide to hold on because you believe he really "should" win.
Third lap and SeeBo has caught his second wind, now starting to close in on first place. You pat yourself on the back for your intelligence since you were obviously right. The bet is gaining in value, so why sell it now when you could win big?
Final stretch, and your heart is beating fast. What is your bet worth if SeeBo is way in front? What if SeeBo is neck and neck? What if he starts to fall behind? Time is running out quickly and his position now is absolutely critical because there is almost no time for major changes in the outcome.
And the Winner Is...
It doesn't matter because now you get the idea. In a nutshell these are the kinds of dynamics involved in options trading. Just as the horse race has a finish line, options have an expiration date, the third Friday (for index options) or Saturday (for equity options) of every month, at which point either they have value or they don't. Prior to that date, the value changes based on the changing odds, being in-the-money or out-of-the-money, and the time remaining until expiration.
The energy and excitement of the race is expressed in different terms in options. The horse's position in the race is the Delta; so if your horse has a Delta of 1 he is way up front, and if he has a Delta of .1 then things are not looking so good. The speed with which he starts to catch up to first place is called Gamma. All the fear, hope, and energy of the race are expressed as Vega, also known as implied volatility. Of course, all of these concepts collapse when the race is over because all you have left is a winner or a loser.
When you buy an option, you are placing a very similar kind of bet to that of the horse race. If Apple is at $200 a share, you can place a $5 bet that it will rise to $220 during the next month. If in a month, Apple's price is $220 or more, the person who sold you the bet has to sell you Apple stock for $220. Unlike in the horse race, the potential profit is limitless because even if Apple stock goes to $300 the seller still has to sell you the stock at $220, and you get to make a cool $75 ($80 profit minus the $5 cost of the option) by reselling those same 100 shares of stock in the open market.
When you buy options and the price is in the winning zone, that option is "in-the-money." Buyers of options like to be in-the-money. Sellers would prefer that the price stay "out-of-the money."
Options are not investments. When you purchase options, you don't receive a dividend. You don't get annual reports or voting rights because you don't have a material interest in the company. When you buy options, all you receive are certain rights that you may choose to exercise.
For every buyer there is a seller, and you can be either. Selling options is also referred to as writing options because you are essentially "writing" a contract that obligates you to sell your options at the agreed price to the buyer at his discretion. In other words, you can think of an option contract as simply a promise, so options trading is merely the buying and selling of legally binding promises.
Just like the bookie in the horse race, the seller can profit only to the extent of the value of the initial bet, the sales price. The buyer is the one hoping to cash in big.
The flip side is that the buyer knows upfront how much he can lose, namely the money he paid for the option. The seller's potential loss may be unlimited if he sold a call, so his broker will require a certain amount of money to be available in order to pay in case of a big loss. This is the margin required to be kept on hand to protect the broker from catastrophic losses in case traders end up being wrong.
Those traders who buy calls want the market to go up, and those traders who buy puts want the market to go down. If you are a seller, you will lose money if the put you sell ends up in-the-money in the same way and proportion as if you had to pay for in-the-money call.