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An option is a contract on some financial asset that involves buying or selling the asset at an arranged price. The benefit of this type of contract is that for a set time period it fixes the price of the asset over a given time period. The prototypical example used to illustrate this is a real estate contract. This is a bit hypothetical to illustrate how options work on the stock market, so bear with me and don't sweat the details as they related to the sale of a home.
Suppose that you have a house for sale, and someone is interested in the house but they are still uncertain about the purchase. Maybe the buyer will be moving to your town provided that they get a job at a particular place of employment. If they move to your town, they are certain to buy the house, but they don't want to commit to buying the house unless and until the job is finalized.
You could setup an option contract for 30 days on the house. The agreement might work as follows. It would give the buyer the option to buy the house for $250,000 within 30 days. This is an optional purchase for the buyer, they are not required to buy the house in 30 days. If they fail to buy the house in 30 days, the contract just expires and they lose their option to buy at that price.
For the seller of the option contract, it's not an option, it's an obligation. So, if you enter into this contract, for that 30 days you can't take a different offer on the house, even if its for a higher price. If home prices in your area spike over the time period the contract is in force such that your house is now valued at $300,000, you still can't sell the house for that amount or for any price, unless and until the contract expires without the other party exercising their rights under the contract.
The book covers: - Option Trader Mindset
- Daily Routine For A Trader
- Risks
- Option Trading Variety
- Covered Calls Strategies
And much more
The buyer of the contract could transfer it to another party. If home prices are rising, other people might be interested in the contract, and since they could save a great deal of money on it with a home, they might be willing to buy the contract for a significant sum. So if the buyer finds out they are not going to get the job, they could let the contract expire worthless, or they could sell it to a third party for say $1,500. If home prices had risen making your home worth $275,000, even though they paid $1,500 for the contract, the ability to buy the house for $250,000 makes it worth it.
For house all we have to do is substitute 100 shares of stock. So an options contract on the stock market has an underlying asset, which is 100 shares of stock and the basic options contract gives the buyer the right to buy 100 shares of stock on or before the expiration date at a fixed price.
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