I liked the intro. There is another use for options, which is insuring against lost gain. Allow me to share a couple of anecdotes.
In January of '95 I knew my 3rd child was on the way and wanted a 'sedan' type car to take the family out. (we had my sports car and a mini-van at the time) I was working at Sun and had been participating in the Employee stock purchase program forever, and Sun stock had gone up a bit so I sold 1,000 shares at $37/share which after taxes and fees netted me enough cash to buy a Chrysler sedan for cash. No loan, no payments, pink slip on the first day I owned it. That was an awesome feeling. In March of that year Sun announced Java, the stock ended up doubling and splitting 3 times. The car I paid 'cash' for was worth 1.6M$ (at the peak of Sun's stock value). Youch!
So my Dad's buddy, a Swiss ex-banker, chastised me for not hedging my bet by buying an 'out of the money' call option, 12 months out. He explained that if the stock never went anywhere it would lower the effective 'gain' from my sale, but if the stock went up a lot it would protect me against having lost out on that value.
Flash forward to 2006, I'm heading for Google, I've got a chunk of NetApp stock and I having lived through the dot com crash I want to diversify. So I sell a lot of my NetApp stock at $35, and buy options for the same amount of stock a year out at $40. (so 'out of the money' by $5). NetApp kept going up and up, and I sold the options a month before they were due (NetApp was trading at $55 and I wanted to keep the gain in the the right tax year) and I got a nice 'bonus' payout on what was essentially the same stock I had sold nearly a year earlier.
The option was there only to protect against missing out on a large rise in the stock price. (which it did, not as well as if I had kept it all but I didn't miss out completely either).
I found that I would keep stocks longer than I should because I was 'worried' about whether or not it was the right time to sell. Options allow you to 'buy insurance' on against that worry, and for me that has made me more willing to make significant changes in my portfolio over the years.
You should've tried a costless collar. Buy a 10%-30% falling put using the proceeds from selling a 10%-30% rising call on a stock you already own (this is critical - as it is your collateral on this trade). Your loss is capped, and you can still participate in gains (Mark Cuban did this back when he sold Broadcast.com - see here: https://www.quora.com/How-did-Mark-Cuban-survive-the-dot-com...).
If your stocks fall, your put is triggered, you sell out at a forced 10%-30% loss, however, as you still have all the cash at that level you can just buy it back, if it falls further you can just buy it back with your cash and redo a collar. If your stocks rise 10%-30%, the call is triggered, and you must sell out at a forced 10%-30% gain, but since you still have all that cash from the rise, you can just go ahead and put on another collar at the new level. Or you can just hold onto your cash.
The collar costs you nearly nothing (simultaneously buying insurance with the proceeds from selling it on things you already own), and you can move around the price levels a lot, "collaring" your wealth to 2 surety levels - aka you will be worth a guaranteed spread between X and Y.
What you wish to do with your cash after the triggers depends on your risk preference, market dynamics, your future predictions of the world economy and the company at hand.
This is a great example of using options to lower risk. You can also purchase insurance outright against a stock falling - if you own a stock and buy puts for it, you'll be protected against the stock falling below the put's strike (since you can literally sell it for the strike price to the person who wrote the puts).
This was originally one of the main uses of options, which is why an option's price is called a premium - it's an insurance premium.
However, if it is stock that is under SEC "rule 144" lockup
(which usually applies for 6 months following an IPO and most M&As), then the legality of doing that is murky.
It used to be outright illegal. The letter of the law has changed, and now it is unclear. I was in this situation, and personally couldn't find a single CPA or lawyer who would say "I believe it's now legal to hedge rule 144 locked shares". (And as a result, I didn't, and lost lots of money, and almost came out with a net loss on a x5 exit)
Not always true: even if you own the shares outright, you may be subject to obscure SEC regulations about what you can do. When I worked at BAC, we weren't allowed to engage in any speculative transactions in any security. Covered calls only.
At my current employer, no options transactions are permitted on company stock, not even covered calls or protective puts. Of course, you can just sell it and do whatever you want with the proceeds.
In January of '95 I knew my 3rd child was on the way and wanted a 'sedan' type car to take the family out. (we had my sports car and a mini-van at the time) I was working at Sun and had been participating in the Employee stock purchase program forever, and Sun stock had gone up a bit so I sold 1,000 shares at $37/share which after taxes and fees netted me enough cash to buy a Chrysler sedan for cash. No loan, no payments, pink slip on the first day I owned it. That was an awesome feeling. In March of that year Sun announced Java, the stock ended up doubling and splitting 3 times. The car I paid 'cash' for was worth 1.6M$ (at the peak of Sun's stock value). Youch!
So my Dad's buddy, a Swiss ex-banker, chastised me for not hedging my bet by buying an 'out of the money' call option, 12 months out. He explained that if the stock never went anywhere it would lower the effective 'gain' from my sale, but if the stock went up a lot it would protect me against having lost out on that value.
Flash forward to 2006, I'm heading for Google, I've got a chunk of NetApp stock and I having lived through the dot com crash I want to diversify. So I sell a lot of my NetApp stock at $35, and buy options for the same amount of stock a year out at $40. (so 'out of the money' by $5). NetApp kept going up and up, and I sold the options a month before they were due (NetApp was trading at $55 and I wanted to keep the gain in the the right tax year) and I got a nice 'bonus' payout on what was essentially the same stock I had sold nearly a year earlier.
The option was there only to protect against missing out on a large rise in the stock price. (which it did, not as well as if I had kept it all but I didn't miss out completely either).
I found that I would keep stocks longer than I should because I was 'worried' about whether or not it was the right time to sell. Options allow you to 'buy insurance' on against that worry, and for me that has made me more willing to make significant changes in my portfolio over the years.