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Let’s talk about options for just a second. If you don’t know anything about options at all, you really need to have a firm grasp of what options actually are. Options, when you think about it – options are more contracts than they are anything else. They really are a contract.
A call – the definition of a call option is, “A legally binding contract that allows the purchaser the right, but not the obligation, to purchase a specific number of shares at a specified price. Which is the same as a strike price, at any time prior to its expiration.”
That is the one thing that you really need to understand about options, is that options do expire eventually. They may have value, or they may have no value, at expiration. The one thing that you can be certain is that they will expire.
Some of them are short-term options, and some of them are longer-term options. You can purchase an option that expires the next day, or you can purchase an option that expires three to five years from now.
If you think about options, an option is simply a contract. It’s just an agreement between you and someone else. If you’re buying an option, if you’re buying a contract, that means that you believe that the price, or the value, of that contract is going to be higher at a future date, than when you purchased it.
The other side of the trade is someone who writes that contract; who sells you that contract. That person believes that the price will be lower in the future than it is at the time that they write it. That’s how they make their money.
So, you have one person on one side of the contract, who believes the contract is going to be more valuable in the future. You have a person on the other side of the contract, who writes that contract, who believes that the value is going to be less in the future.
It’s not that one-dimensional. The fact is, the person that writes you that contract; that sells you that contract, may also hedge that contract with other options. He may go into the market and place a corresponding trade on another option that hedges his risk, in case he is wrong, and the contract goes up in value, rather than down in value.
As an option buyer, you also want to be able to hedge your bets. One thing about being an option buyer is that – there’s only really two absolute rules when it comes to being an option buyer.
Number one is that your contract will fluctuate in value. Number two is that contract will expire, at some future date. Those are the only two absolute rules of options.
Again, those rules are: Number one, it will fluctuate in price. Number two, it will expire at a future date.
If you think of options only as a contract, you’re simply buying and selling different contracts. You’re betting on the future value of that contract. It’s been said a lot of times, and I know it’s absolutely sure, and absolutely true, that the stock markets and the option markets are the biggest casino in the world. Except for one thing. When you go to a casino, and you place a bet – let’s say you go to the roulette wheel, and you place a bet on black. Let’s say you bet $100 dollars on black, and it comes up red.
You lose that $100. You don’t get that back. You lose 100% of your bet. In the stock market, when you place a bet – let’s say you buy an option contract. The price will fluctuate. That’s the number one rule. What will happen is, you can place a $100 bet on an option. Three days later, let’s say the price has gone up.
Not only do you get back your original investment, but you also make a small profit on that. Or you might make a large profit on that. But you get back your original investment plus a profit, if the price goes up.
If the price falls, you get a portion of your investment back. You were totally wrong, but at least you get some of your money back. In the casino, if you’re wrong, you don’t get any of your money back.
That’s the major difference between the stock market and a casino. When you place a bet in the stock market, if you decide that you’re very bullish on a particular stock, and you buy a call option, that hopefully will increase in value, as the stock increases in value. If you’re totally wrong and the stock falls, you can get out of that contract with at least some of your money back, if you act prudently and quickly enough, before expiration.
That is the major difference between the stock market and a casino. So, you have two types of options, basically. You have the call option, which allows you to purchase a contract, that gives you the right to purchase the stock, at a particular price, in the future.
Then you have the put option, which is also a legally binding contract that allows you the right, but not the obligation, to sell a particular number of shares of stock, at any given time in the future, before its expiration. Whether or not you own the underlying stock. They may get a little confusing, but let’s use this analogy.
Let’s say you own a home, and you don’t keep track of the market very well, for your home. Other houses in the market have sold recently, or they were sold in the past. You had no idea. You didn’t keep track of what they sold for, and what prices people were getting for them.
Someone knocked on your door one day, and said, “You know what? I like your house. Would you be interested in selling it to me?”
You say, “Well, it depends.”
“I’m interested in buying your house for one million dollars, but what I’d like to do is – I’m not sure if I can get the financing, or whatever. I would like 90 days to decide. But within that 90 days, I’d like the option to be able to purchase your property for one million dollars. In exchange for you holding that property for me for 90 days, I’ll give you a $500 deposit. Whether I buy the property, or I don’t buy the property, you get to keep that money.”
If you were the owner of that property, and you know that you only purchased that property for 300,000 dollars just a few years ago, the prospect of actually selling your property for a million dollars might be very attractive to you. You enter into a contract with the person. He gives you a $500 deposit, a premium on the contract, to hold the property for 90 days. If he decides to exercise that option to purchase your property for a million dollars, you will have made a 700,000 dollar profit.
The person who owns the contract, who wants to purchase your property, knows that there is a huge development going on, near your home. They’re putting in some super shopping center, and all of a sudden, your property values are going up tremendously, because this is a great place. There’s a resort going in there, and the properties in that area are going to double and triple in price.
You didn’t know anything about that. So you took his $500, and if he does not decide to come back and buy your property for a million dollars, within 90 days, then you get to keep that $500. No harm, no foul.
If he does come and purchase your property for a million dollars, you’ve made a good deal of money on it. Plus, you’ve kept the $500. The guy doesn’t get that back, even if he does purchase your property.
That’s really the analogy. The guy who’s buying the option to purchase your property is hoping that he’ll be able to sell your property for even more than a million dollars, before that 90 day contract expires. That’s what he’s betting on.
But, you know what? What happens to that contract over time? Let’s say the start is today. He gives you $500 dollars. You enter into the contract to sell your property to him for a million dollars. Now he has the right to buy your property for a million dollars, but he’s not obligated to do that.
He doesn’t have to buy your property for a million dollars. It’s not like a purchase contract, like you would when you buy your home. This is just an option to hold your property, and to buy it in a future date for a million dollars.
He goes out, and he tries to find someone else who is willing to take his contract, and purchase your property for 1.2 million dollars. He’s hoping to make a 200,000 dollar profit on that property.
If he finds someone who is willing to purchase your home for 1.2 million dollars, he comes before the 90 days is up. He tells you, “Guess what? I’m going to buy your property for a million dollars.”
You are ecstatic. You are very, very happy about that. He buys your property for a million dollars. He already has a buyer for 1.2 million dollars. He turns around and sells it to them for 1.2 million dollars, making a 200,000 dollar profit for himself. You have a million dollars in your pocket, where you can go out and buy another property.
What happens if he can’t find a buyer? Well, if we started the contract today, and 90 days later, it expires – what happens to that contract over time?
If the 30 days pass by and he still hasn’t found a buyer higher than the purchase price he agreed to, then the value of that contract should actually go down a little bit. It may be originally worth $500. Now it’s only worth $450, because 30 percent of the time has expired; has eroded that contract, to the point where now, instead of 90 days to find a buyer, he only has 60 days in which to find a buyer.
The probabilities of him actually finding a buyer at 90 days, is much higher than it is at 60 days. Let’s say another 30 days has gone by, and he has still not found a buyer for the property, in which he can make a profit.
Well, that contract now is worth even less money. Maybe it’s only worth $250, because two thirds of the time, 60 days, have passed, and he hasn’t been able to find a buyer. The contract that he has entered into with you is now worth much less, because there’s a lower probability that he is actually going to be able to find a buyer of more than a million dollars. 60 days have passed, and he hasn’t been able to find anybody. That little contract that he has, the option to purchase your property, is going to be worth a lot less.
In the last 30 days, he still hasn’t been able to find a buyer. At 90 days, after you had originally entered into the contract with him, that contract date has expired. He hasn’t found anyone to purchase the property for more than a million dollars. But, since he paid you a premium of $500, and the contract expired, you get to keep that $500. Now you are no longer obligated to sell him the property for a million dollars.
That’s essentially what happens when you go to buy a call option, an option that is hoping to profit from the price increase of a stock.