In our last post, we reviewed the first class in Chris Burgess’ miniseries, an Introduction to Options which you can read here in its entirety. In class one, Chris presented us with an analogy on how options work, which breaks down as follows:
Anna strikes a deal with the owner of a house that she wants to purchase. She will give him $2,000 today, and in exchange, the owner of the house will exclusively hold the property for Anna for the next three months. This means at any time in the next three months, Anna can purchase the house for the listing price of $400,000. This ability to have a right to buy something is, in essence, how an option contract functions.
Options take their cues from more traditional stock trading. If you are long on a stock, you buy to open your trade. If you are short on a stock, you sell to open your trade. This core concept is the same when trading options; however, the language is different. For example, if you are long on an option, you purchase a call to open your trade. If you are short on an option, you purchase a put to open your trade. That’s basically the two types of options in a nutshell.
Now, let’s go back to our example with Anna and answer the following two questions. What happens if Anna decides to buy the house and what happens if Anna decides not to buy the house. If Anna goes ahead and purchases the house from Josh, our seller, during her three-month period, Anna will pay Josh $400,000 for the property on top of the $2000 she paid for the ninety days to make up her mind. At the close of the deal, Anna will have gained a house. As for Josh, when the deal closes, he will have sold his house for $400,000 and gained another $2000 for writing Anna’s option contract to purchase the house.
However, if Anna decides not to purchase the house from Josh, she will only lose her $2000 for opening a contract with Josh, which gave her the option to buy the house within three months. She can also purchase a second, third, or even fourth contract from another seller or even from Josh again. As for Josh and his part in this scenario, he will keep the $2000 for the contract, he will keep his house, and he can sell a second contract on his house to another potential buyer.
This brings us to the question: why would Josh want to do this? In this example, Josh has a house that has been appraised for $400,000. He is not currently using it, so he wants to create cash flow from his asset. Josh is fine if the house sells, and he is good if the house does not sell, so he writes contracts on it with an option to buy. These contracts last three months and nets Josh $2000 each time he writes one with a buyer. This is an excellent way for Josh to create passive income from an asset.
I have blogged about options before, but if you are like me and finally ready to take the plunge into the subject, stay tuned to this blog as we dive into Chris Burgess’s upcoming Options class. In the days ahead, Chris will teach how to buy calls and puts while using a paper trading account and explore different options strategies and their advantages and disadvantages. Take care, and we will see you guys in the next post!