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How Options Work - Page .. 1 .. 2
Example: Jane wants to buy a house. After a few weeks of searching, she discovers one she really likes. Unfortunately, she won't have enough money for a substantial down payment for another six months. So, she approaches the owner of the house and negotiates an option to buy the house within 6 months for $100,000. The owner agrees to sell her the option for $2,000.
Scenario 1: During this 6-month period, Jane discovers an oil field underneath the property. The value of the house shoots up to $1,000,000. However, the writer of the option (the owner) is obligated to sell the house to Jane for $100,000. Jane buys the house for a total cost of $102,000; $100,000 for the house plus the $2,000 premium paid for the option. She promptly turns around and sells it for a million dollars for huge profit of $898,000 and lives happily ever after.
Scenario 2: Jane discovers a toxic waste dump on the property. Now the value of the house drops to zero and she obviously decides not to exercise the option to buy the house. In this case, Jane loses the $2,000 premium paid for the option to the owner of the property.
How Options Work Review
- Options give you the right to buy or sell an underlying instrument.
- If you buy an option, you are not obligated to buy or sell the underlying instrument; you simply have the right to do so.
- If you sell an option and the option is exercised, you are obligated to deliver the underlying asset (call) or take delivery of the underlying asset (put) at the strike price of the option regardless of the current price of the underlying asset.
- Options are good for a specified period of time, after which they expire and you lose your right to buy or sell the underlying instrument at the specified price.
- Options when bought are done so at a debit to the buyer.
- Options when sold are done so by giving a credit to the seller.
- Options are available in several strike prices representing the price of the underlying instrument.
- The cost of an option is referred to as the option premium. The price reflects a variety of factors including the type of option, the current price of the underlying asset, the strike price of the option, the time remaining until expiration, and volatility.
- Options are not available on every stock. There are over 3,000 stocks with tradable options, as well as dozens for exchange-traded funds (ETFs). Most equity options represent 100 shares of the underlying stock or ETF.
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