Options are the right, but not the obligation, to purchase something in the future at a price determined in the present. In essence, an option delays an investment decision until we have more information about the market. While some use them to speculate, options are more typically used to manage risk under conditions of high uncertainty.

While we may view options as only for Wall Street traders, they are actually quite commonplace in everyday life. For instance, homebuyers usually ‘lock-in’ their mortgage rate before shopping; if rates go up, they pay the locked in rate. If rates go down, they can take the cheaper rate. Thus, by purchasing a ‘mortgage rate option’, buyers can start shopping for a home knowing exactly what they can afford without having to worry about fluctuating interest rates.

Other forms of options are farming futures, fuel rate swaps, life insurance policies: basically where there is risk to be managed you’ll generally find options that manage it.

Payoffs

Let’s dive in a bit deeper with some visuals to help. We’ll start with a simple payoff graph.

Now, let’s say you paid $20 for some stock. That’s represented by the blue vertical line.

The horizontal (x-axis) is the current market price of the investment. This is the gross price of what you’d get if you sold the investment.

Here, the vertical (y-axis) is the return on the investment. This is the net return of what you’ll get back (the market price less the original $20.)

So, if the price goes above $20, your stock gains value.

And if the stock price falls below $20 your stock loses value.

So this is the full payoff curve; you could lose the entire $20 investment, or you can make money as long as the stock price keeps rising. The breakeven point is at $20.

Options

Now let’s consider an Option, specifically the option to buy a stock (termed a call option in the lingo—options to sell are termed put options.) Here, instead of buying the stock immediately for $20 we’ll instead have the right to buy it at some point in the future for $20. This price is called the Strike price.

Here is the Strike price plotted as the blue line (the same place as before).

When the stock price goes up, the value of the option goes up just like before.

However, unlike before, when the stock price falls below $20 we don’t lose money. Remember: an option is the right but not the obligation to buy something. So, since we don’t have to spend $20 to get something that’s only worth $10, we simply do nothing.

This produces a one-sided payoff curve that is characteristic of options. While the upside of the option is unbounded if the price keeps rising, you can’t lose any money even if the price drops to zero. You can’t lose!

Of course, this optionality doesn’t come for free; you have to pay for the right to buy at $20. This is called the Premium, and for this option we’ll say the cost is $2 (added to the chart as the red line.)

So now we’ll shift the entire payoff curve down by $2 and see the difference.

Before, the breakeven point was $20, the same as the purchase price. But now, the breakeven point is $22: the $20 to buy the stock (at the Strike price), plus the $2 for the option itself (the Premium.) So now we can actually lose money, but that loss is limited to the option Premium ($2).

When we overlay the two curves, we can see why options are so valuable. While the upside is nearly the same, when buying the stock immediately there is the potential to lose the entire $20 investment, while the option loss is capped at $2. Yes, the breakeven point is a bit more, but overall we’ve greatly reduced our downside risk for a (relatively) small amount of money.

Summary

Options and other derivatives can get very complicated, but they will share most of these same basic characteristics. Again, the point is to delay investment decisions until we have more information, thus managing risk under conditions of high uncertainty/volatility.