When volatility is at high levels and the stop loss point on a particular
stock is at about the same price as the cost of an option, Options are the
preferred vehicle. Also when volatility increases the option premium, the time
spreads are the highest. A contract that gives the holder the right to buy 100
shares of the underlying stock within a certain time frame is called "Call
Options". The concept is similar to leasing a car. One has the right to buy this
car at the end of the term and instead of paying the whole sum upfront as in
buying options, payments are made to the financing company in monthly
instalments. When the lease expires at the end of a term and just like an
option, the buyer may wish to continue (buy the car or buy the stock), or let it
expire (give back the car or do nothing on the options side). It's as simple as
that.
A contract, that gives the holder the right to sell 100 shares of the
underlying stock within a certain time frame and at a certain price, is called
the "Put Options". The investor will be guaranteed a sell at your strike price
if the stock falls below this price (called "strike price"). Obviously the
amount to pay will be less if the time bought for protection is shorter. A one
month premium costs less that a two months premium and so on. In theory, if a
downside protection for an infinite time period is wanted, then the premium will
equal the price of the stock.
Since the buyer has the right to exercise or sell his/her puts at any time
prior to the options expiration (the period one has purchased for) both of these
definitions are for buying puts and calls. A very important distinction is
that a buyer has the right while a seller is obligated.
