Understanding option contracts
Options are tools, nothing more, nothing less. Tools can be used to build something, or they can be used to tear something down.
The key is to understand and master your tools and, more importantly, not destroy wealth when your intention is to create it.
There are both call options and put options. Briefly these are as follows:
• A call option gives its owner the option to buy a stock at a specific price, known as the strike price, over a set period of time.
• A put option gives the owner the option of selling a stock at a specific price, again known as the strike price, over a set period of time.
Let’s say your friend has the rookie hockey card for the Habs Jaro Halak and it’s valued at $100. You want the card but don’t have all the money right now. You ask your friend to hold the card for you and agree that you will buy the card for $100 on July 1st. You will pay your friend $3 today for him hold the card.
Come July 1st and Halak has played so well in the playoffs this year that the card is now worth $120. You can buy, from your friend, the card at $100 and immediately sell it again for $120 making a nice profit of $17 (remember you had to pay your friend $3 to get him to hold the card for you).
When you gave your friend the $3 you entered into what is called a call options contract. It gave you the right to buy the card at an agreed upon price at a specific time – or not. Had the value of the card dropped you may not have wanted to buy the card after all. That too was your option, although you would still have spent the $3.
Alternatively, you could have sold your agreement (so long as it was before July 1st) to another person, and let her buy the card off your friend. This is called selling the option contract instead of exercising the option. The contract might have been worth $19 instead of the original $3 that you paid for it. An extremely nice 600+% gain.
Having just $3 at risk to control a $120 investment seems like a very good idea and is called leverage. The most you could lose was $3 and the potential gain was unlimited.
Check back next week and I’ll try to explain some basic strategies and advantages that capitalize on the power of options trading.
