An option is the right to buy or sell something at a specified price
within a specified time frame. Options are commonly used in real
estate, manufacturing, commodities and even pro sports.
The easiest way to define an option is usually with real estate and
something most of us are familiar with. Assume you see a for sale
sign go up on a house you had been admiring. You make an
appointment to see it and find out it is exactly what you had
expected and your wife is doing cartwheels back to the car with
excitement. She wants to buy it immediately but there is just one
small problem. You already own a house and cannot afford to own
two at the same time.
The house is being offered at $245,000. You feel this is a fair price
but you need to sell your house first. You contact the owner and
explain that you want the house but you need time to sell yours first.
In a perfect world he would say "sure no problem, I will just take my
house off the market until you sell yours." As we all know this is not
likely to happen. Here is where the option concept comes into play.
You offer him $5,000 to hold the house for you for six months. To
sweeten the deal you agree to pay him $250,000 for the house
instead of the $245,000 he is asking. If you cannot sell your house
and complete the deal by the last day of the month six months from
today he gets to keep your $5,000 and sell the house to someone
He has "sold" you an option to buy his house for $250,000 at any
time during the next six months for a "premium" of $5,000. This is a
"fixed time" option and will expire "worthless" if you cannot complete
the deal within that timeframe.
Depending on the housing market in your area this is a good deal for
the seller since he gets an additional $5,000 for his property either
by you completing the deal or by your forfeiting of the $5,000 option
premium. This is a good deal for you because it gives you time to fix
up and sell your house before purchasing his and sets a firm price for
Suppose during the six-month term of the option a major company
like IBM decides to build a new corporate headquarters near your
area and housing prices skyrocket. His house is now worth $350,000
but he is committed to sell it to you at the agreed on price. As buyers
we should all be this lucky.
The reverse is also true. Should the state decide to build a prison a
block away and the value of the house drop to $175,000 your liability
would be limited to the $5,000 paid for the option. You could then
simply let your option expire worthless and look for a new house
In this case as in option investing, the option buyer has all the rights
and the option seller has none. The buyer, you in the example above,
paid $5,000 for the rights to buy the house for $250,000. The seller
sold his rights to any future increase in value and locked in a fixed
sales price during the life of the option.
Using the same analogy above but converting it into stock terms it
would look like this.
It is November and tech company XYZ is selling for $24.50 per share.
You think this is a bargain price and you would like to own 1000
shares but your end of year bonus will not be paid until the first week
in January. You suspect that because of the impending tech recovery
that XYZ could easily be worth $30-$35 by then. You can buy a
January $25 Call option for $1.00. This locks in the price at which
you can buy XYZ stock at $25 before the option expires in January.
If XYZ stock rises to $30-$35 as expected you can then "exercise"
you option and buy the stock OR you can sell your option for a profit.
You do not have to exercise the option to profit from it.
If XYZ stock issued a profit warning before January and fell to $10 as
investors dumped the stock, your option would simply expire
worthless and your total loss would be $1.00 per share. Your option
would be worthless because nobody would want to buy XYZ stock for
$25 from you if they could buy it for $10 on the open market. Even if
you still wanted to buy the stock for future growth you would be
better off buying it for $10 on the market than exercising the option.
As in the house example above the "seller" of the option bears all the
risk of price movement, up or down, during the term of the option
contract. Should the stock go up they lose any appreciation over the
"strike price" of the option they sold. Should the stock price go down
they lose that value as well. They are obligated to sell you the stock
at the fixed price for as long as the contract is in force.
Terms to remember:
The "BUYER" of an option has the right but not the obligation to
buy/sell stock at a fixed price within a fixed period of time. The
BUYER buys RIGHTS.
The "SELLER" of an option has the obligation to buy/sell stock at a
fixed price within a fixed period of time. The SELLER sells his
If you like the options education you have been receiving and you are on a free trial then now is the time to subscribe. Don't wait until you miss a newsletter to decide you want to take the plunge.
We have a lot of new traders reading the newsletter and I get a lot of questions. Over the next several weeks I am going to do a ten part mini course on options. How do the strategies work? I will describe all the various strategies including calls, puts, spreads, covered calls, naked puts, straddles, strangles, etc. Stay tuned!
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