Options are basically contracts that states at which price the asset can be bought or sold within a specified time period. Suppose an investor is interested in buying a house that costs $100,000 and really liked it, however, he will keep looking in the market just in case he can find a better house at a better deal. The owner of the house on the other hand is very eager to sell it as soon as possible and will sell the house to the next interested buyer with ready cash on hand. Since the investor liked the house, he asked the owner of the property to hold it for him for a month while he tries to look for a better deal elsewhere. The property owner agrees to hold the house for 30 days if the investor pays $2,000 as a reservation fee, in return, the investor can purchase it at $100,000 regardless if the price of the house goes up or down in market value.
These are the possible scenarios that can happen later on before the contract expires.
- If the investor found a better deal elsewhere, he is not obligated to buy the property, he can simply walk away from the deal.
- If the investor cannot find a better deal, he can purchase the house before expiration at $100,000.
-If the price of the house went up to $110,00 he can exercise the option and buy the house at $100,000 then sell it at $110,00 for a $10,000 profit.
-If the price of the house fell to $90,000 buying it as stated on the contract at $100,000 is unwise so he can just walk away from the deal. The good part about this is that he only lost $2,000 from the payment of the contract instead of losing $10,000 should he bought the house instead at an earlier date.
Options allows both the seller or buyer of the contract to benefit from the deal if it goes the way they planned. However, the risks involved are also present. The example above shows that if the price of the house goes down before expiration, the owner of the house cannot sell it right away to avoid imminent loss because she gave up control of the house to the buyer of the contract. On the other hand, the buyer of the contract technically gives that $2,000 reservation fee to the owner of the house whether or not the buyer would purchase the house.
Before moving on further, trading options would also equate to learning new investment terminologies. To start off, looking at our example, the owner of the house received $2,000 from the investor just to hold the house at a limited time period. The owner of the house made the terms of the contract and sold it for $2,000 therefore she can also be called the writer. The investor who bought the contract for $2,000 to hold the house for a month can also be called the holder since he's the one that "holds" the contract. When referring to options, the writer is the seller of the option and the holder is the buyer of the option. Now that you have a basic idea of options lets move to using other heavily traded equities like stocks on the next page.