Options are one of the most talked about financial instruments but least understood aspects of the financial markets. One thing is for sure, although options can be hard to digest, investors all need to know about them because of their many qualities to reduce portfolio risk. Technically, options give a buyer (or seller) the right, not obligation, to buy (or sell) a specific underlying at a given price for a specific time period. This is a loaded definition, so we will break it down into Layman's terms.
Let's start by comparing options with car buying. Imagine you are in the market to buy a new car. On your journey to purchase a car, you come across the perfect car looking through the classifieds. The next morning, you decide to meet up with the seller. On the drive to see the car, you start getting second thoughts and you become tentative to pull the trigger.
You walk over to the seller and let him know that you're very interested in the car but are still unsure if you want to purchase it. You ask him if you can have 3 months to make a decision and if he would refuse to sell it to anyone else for the listed price of $10,000. He says he'll only put the sale on hold if you pay $1,000 to cover his storage fees and loss of potential sales. You agree and pay him the $1,000 to have the right, but not obligation, to purchase the car within the next 3 months for $10,000.
As time passes by, the car value shoots up to $20,000 because it turns out that it is the safest car ever invented according to Car & Driver magazine. You decide that other cars are just as safe and provide you bang for your buck. At this point you have two choices: 1) you can sell the $1,000 original car contract outright which undoubtedly is 5 to 7 times the value to someone else, or 2) you can exercise the contract for $10,000 and attempt to sell the car yourself at market value. In both cases, you come out on top.
Unfortunately, the other side holds true too. Let's say that the car's value plummets because it is determined that anyone with a screwdriver can steal it. Your agreement with the seller was to purchase the car at $10,000, but now the value sits at $3,000. Since you are under no obligation to purchase the car for $10,000, you can walk away because it makes no sense for you to move forward with the transaction. On the same note, the value of the $1,000 contract itself decreased in value since its price is derived from the car.
And that is how options work. You can own options on company stock and obtain the right to purchase the shares at a specified price. The set prices are called Strike Prices. The cost of the option itself is called Option Premium. Each option has an end date like the 3 month time frame in our car example. This end date for the option is called expiration date.
As always, a solid option course is recommended should you decide to take the plunge into option trading. A good options education course can help you identify the risks of option trading and opportunities to maximize profits.
Let's start by comparing options with car buying. Imagine you are in the market to buy a new car. On your journey to purchase a car, you come across the perfect car looking through the classifieds. The next morning, you decide to meet up with the seller. On the drive to see the car, you start getting second thoughts and you become tentative to pull the trigger.
You walk over to the seller and let him know that you're very interested in the car but are still unsure if you want to purchase it. You ask him if you can have 3 months to make a decision and if he would refuse to sell it to anyone else for the listed price of $10,000. He says he'll only put the sale on hold if you pay $1,000 to cover his storage fees and loss of potential sales. You agree and pay him the $1,000 to have the right, but not obligation, to purchase the car within the next 3 months for $10,000.
As time passes by, the car value shoots up to $20,000 because it turns out that it is the safest car ever invented according to Car & Driver magazine. You decide that other cars are just as safe and provide you bang for your buck. At this point you have two choices: 1) you can sell the $1,000 original car contract outright which undoubtedly is 5 to 7 times the value to someone else, or 2) you can exercise the contract for $10,000 and attempt to sell the car yourself at market value. In both cases, you come out on top.
Unfortunately, the other side holds true too. Let's say that the car's value plummets because it is determined that anyone with a screwdriver can steal it. Your agreement with the seller was to purchase the car at $10,000, but now the value sits at $3,000. Since you are under no obligation to purchase the car for $10,000, you can walk away because it makes no sense for you to move forward with the transaction. On the same note, the value of the $1,000 contract itself decreased in value since its price is derived from the car.
And that is how options work. You can own options on company stock and obtain the right to purchase the shares at a specified price. The set prices are called Strike Prices. The cost of the option itself is called Option Premium. Each option has an end date like the 3 month time frame in our car example. This end date for the option is called expiration date.
As always, a solid option course is recommended should you decide to take the plunge into option trading. A good options education course can help you identify the risks of option trading and opportunities to maximize profits.
About the Author:
San Jose Options is the preferred options education course by risk-averse and sophisticated investors worldwide. Learn why investors use options and why you should greatly consider it too.
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