I was listening to Optionetics Audio Program and George Fontanills came out with a simple analogy on what options is. Just in case you are wondering – the options that I am talking about is stock options.
In a sentence, George said that options enable you to control an asset at a small premium.
His analogy is as follows:
When you buy a car insurance, you have bought a put option. When you buy a house insurance, you have bought a put option on your house. When you buy life insurance, you bought a put option on your life. This means that if anything happens to the insured, the put option will be exercised. If not, the insurer gets to keep the premium you paid.
I have a car worth $25,000, I go to an insurance company and I buy an insurance on my car. I pay a premium of $1000 to insure the car at $25,000, with an expiration of a year. It is the same as an option, there is a strike price ($25,000), a premium ($1,000) and an expiry date (a year).
Let’s say I smashed the car into the wall, I will exercise the claim and receive my $25,000. By paying only $1,000 for the “put option”, I now received $24,000 in profits.
An insurance company actually sells put options.
If a 16-year-old wants to buy a corvette, who has no track record or driving experience, his “put option” is going to cost a lot.
Whereas a 50-year-old man, who has a perfect driving record will have a relatively lower “put option”.
Hence, the volatility, the chance of you smashing into the wall, your history, is going to determine the price of your put option. Likewise, a stock that have high volatility will command a higher option premium because there is a higher probability of the stock reaching the strike price.
It is indeed interesting to have such an analogy. Hope it can help you understand options a little better.