What is a stock option?
• It is not a physical thing
• It is simply a contract/agreement between two parties
• It does not represent ownership in anything
• It grants you certain rights
How does an option work? – Real World Explanation
You find an undeveloped piece of land that you think will increase in value over the next few years. You don’t want to just buy the land, but you would like to tie up the land with a contract so that you have the right to buy the land if you choose to.
The property appraised for $25,000. You ask the owner to draw up a contract that will allow you to buy that land anytime within the next three years for a set price of $25,000. The owner agrees and you pay him $2,000 for the rights to this contract. You aren’t obligated to buy the land. If you decide not to purchase the land, your contract will expire and you will lose your initial investment of $2,000.
Good news!
The area around the land has been developed and your lot becomes a prize real-estate location. Today the appraisal price of the land is now $100,000. You’re in the money! You own a contract that says you get to buy that land for only $25,000.
You have 3 choices…
1) Exercise the option to buy the land for $25,000 and keep the land.
2) Exercise the option to buy the land for $25,000. Then, sell the land on the open market and pocket the difference between what you sold it for and what you paid for it. $100,000 – ($25,000 Purchase Price + $2,000 Contract Price) = $73,000 or 270% return on investment.
3) Sell the contract to someone else. Without putting up the money to actually buy the property, you could simply turn around and sell the contract for a higher price than what you bought it for. You sell your contract to a local land developer for $20,000 and you walk away happy. You just made an easy $18,000 or a 900% return on your original investment of $2,000!
Contract Rights – Real World Explanation
You have a 1-year gym contract. It gives you the right, but not the obligation, to go to the gym whenever you want for a full year.
If you don’t exercise your rights to go, then you lose the money you paid for this right. After a year, your membership contract will expire and you will no longer have the right to work out at that gym.
Financial Leverage – Why You Can Make Such a High ROI with Options
• An options trader only needs a small amount of money to participate in the movement of a larger amount of money.
• Every one contract represents 100 shares of stock. You don’t need to own 100 shares of that stock to buy a contract for it.
4 Components of an Option
• Underlying Security: Options are based on an underlying security (stock). The price of the option will rise and fall with the price of the stock.
• Right, Not Obligation: Owning an option gives you the right, but not the obligation to buy or sell the underlying security (the stock).
• Specified Price: The option gives you the right to buy or sell 100 shares of stock at a specified price.
• Time: Your right to buy, or sell, the underlying stock expires on a given date. After that date, the option ceases to exist. The stock does not go away but the option expires.
Buying Put & Call Options
Buying a call gives its buyer the right, but not the obligation to BUY shares of a stock at a specified price on or before a given date. CALL = Right to BUY.
A CALL option increases in value when the underlying stock it’s attached to goes up in price and decreases in value when the stock goes down in price.
Example:
You buy an IBM December 95 CALL. You have the right to buy 100 shares of IBM for $95/share on/before the 3rd Friday of December. IBM comes out with a new product and the share price jumps to $127. You own a contract that says you can purchase 100 IBM shares at $95/share. You get a $32 “discount” off of the “retail” price.
Buying a put gives its buyer the right, but not the obligation, to SELL shares of a stock at a specified price on or before a given date. PUT = Right to SELL.
A PUT option increases in value when the underlying stock it’s attached to goes down in price and decreases in value when the stock price goes up.
Example:
You buy an IBM December 130 PUT. You have the right to sell 100 shares of IBM for $130/share on/before the 3rd Friday of December. The price of IBM now falls in price to $76/share. Everyone who owns IBM stock shares has to sell it for $76/share, but you own a contract that says you can sell it for $130.You hold a contract that says you can sell something for more than the market value. Someone who owns IBM shares is facing the pressure of selling it at $76, but they would sure love to own a contract that says they could sell it for $130. They may be willing to buy that contract from you.
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About Trader Travis
Travis Wilkerson (aka Trader Travis) is the co-founder of the MarketClub Options program and the 2019 United States Investing Champion (Enhanced Growth Division).
Travis has mentored thousands of trading students, teaching them the same strategies he used to reach financial freedom after years of poverty. Travis believes that investing strategies should be simple and available to all – giving people a hand up, not a handout.
