Why options exist

Why hand over real money for a choice you might never use? It is a fair question, and it has two honest answers. Between them they cover almost everyone who ever buys an option.

Reason one: a view with a small, fixed risk

Suppose you believe Infosys will rise over the next month. One way to act on that is to buy the shares outright, which ties up a large sum and exposes all of it to a fall. Another way is to pay a small premium for a call, the right to buy at a set strike. If you are right and the stock climbs, the call can gain a great deal relative to the small premium you paid. If you are wrong, the most you lose is that premium.

Look at the shape of that deal: a small, fixed, known risk in exchange for a large, uncertain reward. That shape is what draws many traders to options. It lets you back a view while controlling a large exposure for a small outlay, with your downside capped at the premium. The catch, and there is always a catch, is that the stock must move enough, and in time, or the premium quietly drains away. Later chapters give that catch its due.

Reason two: protection, like insurance

The second reason is the opposite of a bet. It is safety. Suppose you already own Infosys shares and you are nervous about a fall over the next few weeks, perhaps before the company reports its results. You can pay a premium for a put, the right to sell at a fixed price. If the stock drops sharply, your right to sell at the higher locked price cushions the loss. If the stock does not fall, you let the put lapse, out only the premium, the way an insurance premium is spent on a year with no claim.

This is exactly how insurance works, and it is worth seeing options this way as often as seeing them as bets. A put bought against shares you own is protection you hope you will not need.

So options serve two very different people: the one taking a view who wants a small, capped risk, and the one protecting a holding who wants a cushion. The premium is the price of both. It is not wasted money. It buys either a cheap way to back an opinion, or insurance against a loss. Whether it turns out worth paying depends on what the underlying does before expiry.

What to carry forward

People pay for options for two reasons. The first is to take a view while risking only a small, fixed premium, with a large potential reward if the underlying moves their way. The second is to protect something they already own, paying a premium for a cushion the way they pay for insurance. In both cases the premium is the honest price of the flexibility, spent whether or not it pays off, which is why the rest of this course keeps asking whether that price is worth paying.

You now know what an option is and why anyone wants one. The next chapter meets the only two types there are: calls and puts.