For almost two years now, I have been blogging my way through various classes offered here at Tradesmart University. The goal has been to look inside each class to see if the class in question might be a good fit for you to take on your trading journey. Most of the classes I have covered have been about trading stocks, but I am now shifting gears to trading options.
I have touched on options before in my Foundations of Stocks and Options series, and you can read the options-related blogs by clicking on the Options tag on the right-hand side of this page. This will also bring up other blogs which have been tagged as options related as well. However, instead of a broad overview, this time, I am looking to get my head around how options function and why they might be right for me to trade. So, let’s get rolling with an overview of options with Chris Burgess’ two-part class, The Options Transition.
In Chris’ first class, he presents a real estate analogy on how options work, breaking down as follows. Anna is looking to purchase a house. After much searching, she finds a great deal for $400,000. However, Anna is unable to put money down on the house close the deal, but she really wants to lock-in that particular house at that specific price.
So, Anna strikes a deal with the owner of the house. She will give him $2,000 today, and in exchange, the owner of the house will exclusively hold the property for the next three months just for Anna. This means at any time in the next three months; Anna can purchase the house for $400,000. However, this brings up two related questions: what if Anna ultimately does not want to buy the house, and what if the price of the house goes up over the course of her ninety days?
Anna has an appraiser look at the house and report back to her what the house is currently worth. The appraiser reports back the house is worth $375,000 or $25,000 less than what the homeowner wants. So Anna decides it is not a wise investment to purchase the house at her locked-in price, so she lets her deal with the homeowner expire after ninety days. Her loss on the deal is $2,000, but it could have been much more. If she had purchased the house at $400,000, she would have immediately lost $25,000 due to the reduced price of the appraiser’s report.
The reverse of the above paragraph plays out this way. The appraiser reports back the house is worth $425,000 or $25,000 more than what the homeowner wants. Anna decides this is a wise investment because as soon as she purchases the house for $400,000, she will gain $23,000 in instant profit. Minus the $2,000 which it took to secure the deal initially.
This is a basic example of the flexibility which trading options can provide. You can lock in a price point on a stock for a fee. If the stock goes up, you can purchase the stock and then sell it for a profit. If the stock goes down, you avoid trading the stock, and even though you have lost the money you have put down to secure your option, there is a fair chance you have lost less than you would have if you had purchased the stock. Needless to say, if you are like me and find the concept of what options can provide interesting, then join me next week for part 2 of An Options Analogy.