An Example
Say for example 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 $1,000,000. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, your profit is $797,000 ($1,000,000 - $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 the obligation to do something. You can always let the expiration date go by, at which point the option is worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option.
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 $1,000,000. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, your profit is $797,000 ($1,000,000 - $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 the obligation to do something. You can always let the expiration date go by, at which point the option is 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. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.
posted by Raphael Blogger @ 1:29 PM
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