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What are Options?
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"New"- A stock option course is now available
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We hope that our school improves your trading knowledge.
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Good Luck
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What are Options?
When asking a trader if he or she has ever traded options, most traders will answer back saying “What?” in a puzzled tone.
Stock trading has become such a popular form of investment over the last couple of years, that other forms of trading are often forgotten about, even if they are quite profitable.
For beginners, starting to trade options can be quite tiring. Especially as it requires learning new terms and concepts.
Like stocks or Forex, Options are another form of investing. They are classed as a derivative, meaning that their price derives from stocks or indices.
Ok…so what is an ‘Option’?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying stock at a specific price at a pre-determined date.
Sounds like some term that only a lawyer would use, no?
Well, actually it is quite simple.
For example: Let’s say John is a farmer who owns 5 Akers of land and Peter is a hotshot from Wall Street that wants to leave his fast paced life and go and live in the country and build his own house.
After searching around, Peter comes across John’s land and immediately falls in love with it, due to the surroundings, view and wildlife. Peter immediately knows that this is where he wants to build his dream home, so he approaches John asking if he can purchase 2 Akers of his land.
Just from seeing the suit and the Porsche convertible parked outside his house, John asks for $100,000, double the amount of the land’s value.
Just remember that John is not your average Joe, and at the age of 87 he has learnt a thing or two
Nearly fainting from the price, (knowing that he doesn’t have that kind of cash lying around) Peter and John both agree to a contract where John has the right to buy the land in 4 months time.
As a business man himself, John asks for a down payment of $10,000 (premium) to guarantee that he won’t lose out if peter suddenly decides to back out of the deal.
Remember: No matter what happens to the value of the land within those 4 months, Peter has the right to buy the land at $100,000.
Now let’s jump 4 months ahead and see the different scenarios:
1) During the 4 month period a drilling company approaches John, stating that they think that
if they drill into his land,they will find oil. They are willing to purchase the land for half a million Dollars.
In this case, Peter will profit from the deal as he has the right to buy the land at a pre-determined price and date ($100,000). John is obliged to sell him the land if Peter wants to buy it.
2) On the other hand, if a developer decides to build a shopping mall in front of Johns view, Peter can decide not to buy the land. In this case, Peter would have lost his initial premium of $10,000.
Nice story, but how does this connect to stocks?
Let’s say Microsoft is trading at $23 per share.
To profit from the rise you have to have enough cash to purchase the stock.
To purchase 100 stocks you will require $2300. A lot, no?
Well, if you think that the price of the stock is going to rise, you don’t necessarily need to buy the stock itself; you can buy an option instead.
Or in other words, you can pay a premium to buy 100 shares at a later stage in time, but at the price of $23 per share.
When talking about U.S options, 1 option is worth in value to 100 shares.
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For active traders and investors trading the
Forex and Stock markets.
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Always have a trading plan.
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