You are driving along in your old car that is about to die. Fellas, your woman hates this car and ladies, you hate being seen in this car. As you are driving down the road you see a sign for a garage sale, and you decide to stop (besides you don’t have A/C in your car and need to cool off by getting out of the car) (I know someone can relate to this). As you check out the inventory, you see an old car in the garage for sale. It looks nice and has decent mileage. The owner tells you that they just want to sell it because it belonged to their deceased spouse and they don’t value the car as much as they once did. You decide to buy the car, but don’t have the money or just don’t want to commit now. So the owner says that they will hold it for you for 5 months if you pay $500 today and the price of the car later. They promise to sell it to you for $5000 at anytime during the 5 months. Though you planned on spending the money on something else, you pay the owner the $500 and go home (you’ve cooled off from the long drive in your “A/C – less” car.
Afterwards, one football core workout of the two following scenarios occurred:
You come back in three months with your $5000 in hand to purchase the vehicle. Before you hand over the cash, you ask if you can get the car inspected. The owner agrees and you both hop in and drive to the local repair shop (they are not going to just let you take it on your own…you may run off with their car and $5000). Upon arrival and inspection, the shop tells you that the car you’re about to purchase is actually one of the rarest cars they’ve seen. You, not being the car expert, ask what kind of car is it and how much is it worth. They tell you it is a 1957 Ferrari 250 TR and that it is worth over $8,000,000. Because you paid your $500 3 months ago, the owner is obligated to sell you the car for the agreed upon price – $5000. So you pay the owner and thank them for the car (they still profit because they received $5500 – $500 for the “option” and $5000 for the price of the car). So now you have made a profit of $7,994,500 ($8,000,000 – $5000 – $500 = $7,994,500)
You come back in three months with your $5000 in hand to purchase the vehicle. Before you hand over the cash, you ask if you can get the car inspected. The owner agrees and you both hop in and drive to the local repair shop. Upon arrival and inspection, the shop tells you that the car you are about to purchase has an engine and transmission that is busted, the frame is rusted and looks like it has been in several accidents. They believe the car is worth $300 (including the cost to repair). Fortunately, you are not obligated to buy the vehicle. However, you lost your initial of $500. You and the owner part ways and you continue to drive you “A/C-less” car.
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 choose not to buy the stock (“let it expire”), at which point the option becomes worthless. If this happens, you lose 100% of your initial investment (called the “premium”), which is the money you used to pay for the option. Second, an option is merely a contract to trade “something” during a specific timeframe in the future. This is why options are called derivatives, because the option “derives” its value from something else. In our example, the car is the underlying asset. So, the amount of the option is “derived” from the value of the car. Most of the time, the underlying asset is a stock.
Is this helpful? Would you like to receive more of this? Send me your investment, credit, or personal finance questions, and I will create a reader-friendly example explaining it.