Image courtesy of iosphere at freedigitalphotos.net
There are many different ways to invest in the stock market. Would you consider investing in “the right” to buy an asset? If you trade stock options, you are buying the right to buy shares of stock. The definition of an option is a contract that gives 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.
This scenario may help to further clarify how options work… The good new is you have finally found your dream home! The bad news is you don’t have enough cash to buy it. You decide to try to strike a deal with the owner that gives you the OPTION to buy the house for $400,000 in six months after you come up with the cash. For this OPTION you pay the owner $6,000.
Consider these two potential story lines:
- During an inspection, the inspector comes across a stream in the back yard that is FULL OF GOLD! The property is now worth $5 million and because you purchased the option, the owner is obligated to sell you the house for $400,000. The profit on this transaction would now be $4,594,000 ($5 million – $400,000 – $6,000).
- During an inspection, the inspector comes across waste oil that has contaminated the soil. The cleanup costs will run into the millions. What you thought was your dream home now turns out to be your worst nightmare. But don’t fret! Because you bought an option you are not obligated to purchase the property. You will however lose the $6,000 you paid for the option but you have saved millions!
Options are derivatives; they derive their value from something else. With stock options, most of the time, the underlying asset is a stock or an index. Click here to learn more about stock options!
Please click like if you trade stock options.
