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 else.

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 his property.

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 elsewhere.

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 RIGHTS.

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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!

Jim Brown

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