For the uninitiated, options are the right to buy or to sell something–practically anything really–at a set price over an agreed period of time. I can call my broker and buy the right to purchase Yahoo at $35 a share between now and April 15 next year for $2.32 a share. I can also buy the right to sell Yahoo at $25 a share for $1 a share. I might do this if I owned the stock and wanted to protect my investment in case of a decline. With Yahoo trading at about $32 a share, neither option would make me any money right now. But either one could make me money, and possibly lots of it, if there were to be a major move in Yahoo either up or down between now and April 15. In essence, I would be buying volatility.
Yahoo dropping to $2 a share or zooming upward to $200 in the period before the options described above expire would surely destroy a significant chunk of the wealth of those who sold options to others that allow them to sell at $25 in the former case or to buy at $35 in the latter case.
But, it turns out that most stock and commodity options expire worthless. And so, those selling the options walk away with the premium paid by the buyer and then reinvest that money or spend it elsewhere. These option sellers (or “option writers” as they are often called) make a very handsome living during times of low volatility such as we have seen since the stock market bottomed in 2009.
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