Not Just More or Less but Different

Options are about choice and the freedom to do something, exercise your option, or not do that something and let your option expire. An option is the right but not the obligation to do something; in our context, it’s the right to buy or sell stock at a predetermined price before the option’s expiration date. For this reason, options are obviously very different than ownership of the underlying stock. While it’s true that if you own stock you always have the freedom, the “option,” of selling your stock, that’s a pretty drastic choice; there’s no middle ground. It’s the choice inherent in ownership of an option, or the premium collected in selling an option, and the ability to enjoy the shades of gray between owning the underlying stock and not owning the underlying stock that make options such a useful tool. The owner of the option gets to make this choice but pays money for the privilege. The seller of the option doesn’t get to make the choice, he’s at the mercy of the option owner but he is paid for being at the mercy of the option buyer and he’s often paid very handsomely.

This choice also means that options, when combined with other options in spreads and combinations and when combined with stock, result in risk/reward payoffs that are very different than stock alone or options alone can generate. If standard asset allocation between stocks, bonds, commodities, precious metals, and so on is diversification, then it’s diversification ...

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