This week, we digress from our position building to touch upon some important fundamentals. The question du jour is, "What are options?"

The answer is simple. They are parts of stock much like hydrogen and oxygen are parts of water. You cannot claim to have consumed water but not H₂O. Likewise, you cannot claim to have traded stock but not options. Options are simply proxies for the elements of risk and reward inherent in stock. Look at it this way: you cannot buy stock without acquiring the elements of risk and reward the stock possesses. Since options simply represent these elements of risk and reward, a position in stock is equivalent to a specific type of option position. This is not surprising. After all, if we can use options to "disassemble" stock, we should be able to use options to rebuild stock. Indeed, we can.

If we simultaneously purchase a call and sell a put on IBM, we have created a position called synthetic stock (note: both options have the same strike and expiration.) The synthetic stock possesses the exact same risk and reward characteristics of the stock itself.

With options, we extract stocks' elements of risk and reward and deal with these elements separately. A primary benefit of this is that we can fine-tune our exposure in the markets. For example, the act of buying a put to protect a long 100-share IBM stock position is actually the act of closing out the short put position embedded in the 100 shares of stock. Remember, 100 shares of stock is the same as buying a call and selling a put as described above. Therefore, if we buy an actual IBM put to protect 100 shares of IBM stock, we have really just closed out the "invisible" short put inherent in the stock. This leaves us with the equivalent of a long call position. In other words, we have retained only the element associated with the reward of a rising stock price, and we've eliminated the element of risk associated with a declining stock price. In this way, we've adjusted our exposure on-the-fly by taking a big chunk of risk out of the stock.

This concept is clarified greatly in ChartBender's video called "Investigating The Covered Call", which is available at a deep discount to OLI readers.

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