According to Wikipedia, an option (finance) is a contract between a buyer and a seller that gives the buyer of the option the right, but not the obligation, to buy or to sell a specified asset (underlying) on or before the option’s expiration time, at an agreed price, the strike price.
Imagine you found a fortune teller who actually is the real deal; and she gave you a hint on Intel inventing the microprocessor…
How much money have you made if you hold a nice chunk of stocks before the iphone invention were made public by apple?
That my dear friend is the power of speculation… and that is where the flexibility of options trading get is root of power. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option; you have to be correct in determining not only the direction of the stock’s movement, but also the magnitude and the timing of this movement.
Investopedia give a good example of how the option concept applies to an everyday situation.
Say, for example, that you discover a house that you’d love to purchase. Unfortunately, you won’t have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.
Now, consider two theoretical situations that might arise:
1. it’s discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million – $200,000 – $3,000).
2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset.
Back to our apple example; an option trader made a bet that in 6 months apple stock will be trading 30 bucks above the present time price; but hey… the fortune teller gave you higher expectations; she said the stock were going to be over 100 bucks in increase. Either way, the trading price in 6 months will be higher than the present price; so the options trader buys a call contract.
Assuming that the apple stock of our example is trading at US $50 dollars (the real value price on mid July 2006 give or take), you bought a call contract to buy apple stock at $50 dollars. Well, apple launched the iphone around in early 2007; and by the time your call contract (mid January 2007 following this example), apple stock where selling over $90 bucks.
Since you bought a contract, you have the right to buy the stock, that worth $90 bucks, for $50.
Selling this stock to the open market makes a net profit of US $40 dollars per stock immediately. The $50 dollar value, stated on the contract is referred as the Exercise or Strike price.
Now; let’s assume that your fortune teller is just like any other… a scam.
If the stock were trading for $20 bucks instead of $90, buying these stocks at $90 dollars is a stupid move. In this situation you can simply choose your right to buy the shares from the open market and let the options expire worthless. Of course you’ll have to pay the contract fees, which are named the Options Premium.