What Are Options? – An Explanation in Layman’s Terms

Options are one of the most talked about financial instruments but least understood aspects of the financial markets. One thing is for sure, although options can be hard to digest, investors all need to know about them because of their many qualities to reduce portfolio risk. Technically, options give a buyer (or seller) the right, not obligation, to buy (or sell) a specific underlying at a given price for a specific time period. This is a loaded definition, so we will break it down into Layman’s terms.

Let’s start by comparing options with car buying. Imagine you are in the market to buy a new car. On your journey to purchase a car, you come across the perfect car looking through the classifieds. The next morning, you decide to meet up with the seller. On the drive to see the car, you start getting second thoughts and you become tentative to pull the trigger.

You see the car in person and decide that it’s beautiful, but are still unsure you want to buy the car. So you ask the seller if you can have a window of time to buy the car for $10,000. He agrees to hold the car if you pay a small fee to cover the cost of storage and loss of potential sales. You pay the agreed fee of $1000 and now own the contract that gives you the right to purchase the car in the next three months for $10,000.

As time passes by, the car value shoots up to $20,000 because it turns out that it is the safest car ever invented according to Car & Driver magazine. You decide that other cars are just as safe and provide you bang for your buck. At this point you have two choices: 1) you can sell the $1,000 original car contract outright which undoubtedly is 5 to 7 times the value to someone else, or 2) you can exercise the contract for $10,000 and attempt to sell the car yourself at market value. In both cases, you come out on top.

On the other hand, let’s say that the car is determined to be a complete lemon by national media. The market value for the car is now $3,000. Your contract to purchase the car for $10,000 is now underwater because why would anyone exercise the option for something they can buy for less. With that in mind, the $1,000 contract itself could have decreased by 5 to 7 times its original value. You allow the contract to expire after 3 months and you walk away losing $1,000 during the ordeal.

And that is what options are in Layman’s terms. The car in our example is equivalent to an “underlying”. The price of the contract is called a “premium”. The agreed upon price of an exercised option is called a “strike price”. The date an option expires is called an “expiration date”. Option values are derived from the underlying.

As always, a solid option course is recommended should you decide to take the plunge into option trading. A good options education course can help you identify the risks of option trading and opportunities to maximize profits.

Learn more about the preferred options course by risk-averse investors worldwide. See why options are important and should be considered for all portfolios.

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