I think we can all agree that options are very important financial instruments. However, what exactly is an option? Investopedia states that options are contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. Sounds great and all, but it doesn't help those that don't understand financial speak. So I'm going to describe options so anyone can understand them.
As an analogy, we will compare options to the art of purchasing a car. So you are looking for a car on Craigslist and you find the perfect one. You contact the seller and arrange a viewing of the vehicle. When you pull up, you notice that the car color isn't as vibrant as the online photo. However, you are still very interested in it. You can't make up your mind to throw down for this car because of the cumbersome color; although, you know the price is good.
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.
Before you decide to jump into options, it's important to invest in yourself. I recommend that you look into a good option education program unless you feel you can duke it out yourself through books and online articles. A good options course will help you build a strong option foundation where you'll be able to trade like the pros maximizing profits while mitigating risks. Happy Trading!
As an analogy, we will compare options to the art of purchasing a car. So you are looking for a car on Craigslist and you find the perfect one. You contact the seller and arrange a viewing of the vehicle. When you pull up, you notice that the car color isn't as vibrant as the online photo. However, you are still very interested in it. You can't make up your mind to throw down for this car because of the cumbersome color; although, you know the price is good.
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.
Before you decide to jump into options, it's important to invest in yourself. I recommend that you look into a good option education program unless you feel you can duke it out yourself through books and online articles. A good options course will help you build a strong option foundation where you'll be able to trade like the pros maximizing profits while mitigating risks. Happy Trading!
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