Got to stop saying "last shot"!
Much of what I have read in replies is true, but I again feel the need to clarify my thinking some more. Options can be used to either increase on decrease the volatility of a portfolio. Specifically, if you sell calls you get money in your pocket for reduced potential future returns. If you buy calls you spend some money for potential future leveraged returns. Similarly, if you buy puts you reduce your downside risk, and if you sell puts you can leverage a falling stock.
So, options can be used to either increase or decrease the volatility of your portfolio, this I will agree with. I think a point was made that some people (like me with my Intel stock) were willing to spend a little money in order to get the reduced volatility. If we assume this is the "financial function" of the options, and people are willing to pay some amount of money, say $x for the reduced volatility, then somebody else will indeed get $x for assuming the risk of the higher volatility. This would lead one to believe that the only long term average money making proposition with options is to buy calls, or sell puts as these are the actions that increase volatility. In doing so, you are collecting a small insurance premium from those who want reduced volatility. However, I have seen no such data to indicate the money does indeed flow this way, as I believe the greed for leveraged returns outweighs the financial function.
In terms of the "zero sum" game comment, here is how I think about it. Imagine a couple of guys get together and each put a million bucks into buying a restaurant. This is like buying capital, or the stock. The restaurant then makes money by selling food, and returns the profits to the owners. This is how stocks make an average 10% return, by producing product and making a profit.
Now imagine there are a couple of guys standing on the sidewalk looking at the restaurant. One of the guys says to the other, "I bet you a hundred bucks that restaurant loses money next quarter." The other guy takes the bet, and at the end of the quarter they settle up. This is like options trading. There is no underlying value, just the agreement between the people, of which one will make exactly the same amount of money the other loses. Of course options are much more complex than this with different values and time frames, but the concept is the same.
You can imagine one of the restaurant owners going out and placing such a bet. If the restaurant makes money he is happy. If the restaurant loses money he collects on his bet, partially offsetting his loss on the restaurant. This is how the options can serve as a hedge...
But...why in the world would you buy into the restaurant and then bet against it? The only reason I have seen is for the tax advantage of delaying income for capital gains purposes.
In terms of using options to adjust portfolio volatility, I personally accomplish this by adjusting ratios on various "types" of stocks and percentage of assets in bonds. This way I can adjust volatility and leave all my money in income producing instruments... of which options are not one.
--Alan
Wow! I really stepped into a firestorm with this one:-)
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