What are options?
An option is a chance to buy or sell something by betting it is going to rise or fall in price.
It is buying the “Option” to buy or sell but not the “Obligation” to do so.
Options can be thought of as a contract between two parties in which the buyer purchases the right to buy or sell shares of stock (or some other security) at a predetermined price from or to the seller. This has to happen within a certain period of time.
For example, let’s say the stock price of Coca-Cola is $50 and the premium is $1.00. If you buy 100 shares, the total price is $1.00 x 100 = $100. If the strike price is $55, the stock price of Coca-Cola must rise $5 before the option is worth anything. Two weeks later the stock price is $60. The options contract increases with the stock price and is now worth $2.50 x 100 = $250. To find your profit, subtract what you originally paid by the stock price, $250 – $100 = $150. Now, you can sell the options and take your profit!
- Strike Price—price at which the option is to be bought or sold (also known as “Exercise Price”)
- Premium—the price the option buyer pays to the option seller to acquire the option
- Expiration Date—the date by which the option must be bought or sold or it will become worthless
Types of options
- Call Options (the right to buy)
- Put Options (the right to sell)
Call options = Right to buy
A call option allows you to buy a stock from the seller who sold you the option at a fixed price.
For example, if you bought a call option for Apple, the option would say that you can buy Apple stock for the strike price before the expiration date. So, if the stock rises above this strike price, you can buy the stock for less than the market value. If the price never rises above the strike price, however, your option won’t be worth anything.
Put options = Right to sell
A put option allows you to sell a stock to the seller who sold you the put option at a fixed price.
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For example, if you bought a put option for Google, the option would say that you can sell the stock for the strike price before the expiration date. So, if the stock falls below this strike price, you can sell the stock for more than the market value for a profit. If the price never falls above the strike price, however, your option won’t be worth anything.
Calls and puts are valuable if you know what direction the stock market is going to move. If you don’t, you might be better off using the straddle strategy. In the straddle strategy, the buyer has a call and a put, both with the same strike price and expiration date. Straddles are very risky because they are only profitable if there is a large jump in either direction; a small change in the stock market will only result in a loss.
Since options expire, though, if you don’t sell or exercise your option before the expiration date, you will lose your entire investment.
How options are used in different industries
Real Estate: Developers can compile large areas of land from separate owners. For example, if a developer wants to build a new neighborhood, he can pay for the rights to buy numerous plots close together, but he won’t have to buy them unless he is sure he can buy all the plots he needs.
Film and TV: Producers can buy the right to enact a script or book. For example, Warner Bros. optioned the rights to the Harry Potter books, which ended up making more than $7 billion.
Lines of Credit: Allow potential borrowers to borrow within a specified time period but without obligation. For example, a credit card provides a line of credit.
Convertible Bonds: These can be converted into common stock (at the buyer’s option) or be bought back at specified prices (at the issuer’s option). Many start-ups issue convertible bonds to investors when raising money for the company.
Mortgages: Mortgage borrowers can repay the loan early, which is similar to a callable bond option.