Why do options exist?

Why do options exist?

Why would anyone pay for an option? Think about insurance. A buyer pays for agreed protection, and someone else accepts a financial risk. A put option can serve a similar purpose for shares. Options also have other uses, including speculation. Today we will focus on protection. Our people, company, and prices are fictional.

Alex wants protection

Meet Alex. Alex already owns one hundred shares of Harbor Goods. The shares trade at fifty-two dollars each. Alex wants to keep owning them, but worries about a big fall. Alex would like the right to sell those shares for fifty dollars each during a set period, even if the market price falls much lower.

Sam is willing to buy

Sam sees the other side. Sam studies Harbor Goods and estimates that a share may be worth around sixty dollars. Sam is willing to buy one hundred shares for fifty dollars each and sets aside five thousand dollars. That valuation is an estimate. Sam could be wrong, and the business could weaken. Sam must accept that risk.

The agreement connects their needs

Alex pays one hundred dollars for a put option. This payment is the premium. Alex gets the right to sell one hundred shares at fifty dollars each under the contract. Sam sells a put and receives the premium for accepting the obligation to buy if assigned. Being assigned means being required to complete that purchase. Think of Alex buying protection and Sam accepting its risk. An option is a securities contract, not an insurance policy.

If the stock falls to $35

At expiration, imagine the shares fall to thirty-five dollars. We assume Alex exercises the right to sell at fifty dollars. That brings in five thousand dollars instead of the thirty-five hundred dollars the market would pay. Subtract the one hundred dollar protection cost. Alex has forty-nine hundred dollars in net sale proceeds. This is money from the sale after the premium, not the profit on the original investment.

Sam accepts the other side

If assigned, Sam pays five thousand dollars and receives one hundred shares now worth thirty-five hundred dollars. Sam received one hundred dollars earlier. The combined position has a fourteen hundred dollar loss before costs. Sam may still want the business, but a belief in its value does not erase this loss or promise a recovery.

If the stock finishes at $55

Now reset the example. Suppose the shares finish at fifty-five dollars and the put expires without exercise. Alex keeps the shares. The protection cost one hundred dollars. Sam keeps the one hundred dollar premium and makes no share purchase. Paying for protection can make sense even when it is not used, just as insurance can.

What the protection changes

The graph compares Alex selling at different expiration prices. The gray line shows the shares alone. The blue line includes the put and subtracts its one hundred dollar cost. Below fifty dollars, the put provides a floor of forty-nine hundred dollars in this example. Above fifty, the protection still costs one hundred dollars. These lines show net sale proceeds, not investment profit.

Protection on one side. Risk on the other.

Both sides get something they want. Alex pays for protection. Sam receives payment for accepting a purchase obligation at a price supported by Sam's research. Neither side gets a guaranteed profit. Sam could lose forty-nine hundred dollars if the stock becomes worthless. Real trades go through brokers and clearing systems. Exercise and assignment can happen before expiration. These simplified examples exclude other costs. Explain why Alex pays and what Sam promises before moving on.