Explain Option Trading
To explain option trading we must have an idea of what an Option is and how it works. So here goes, let’s say your good friend or neighbour has a priceless painting that he is considering selling. He is asking for $15000 for it. You feel the painting is appreciating in value but you would first like to research its market value it would be an ideal purchase to resell for a substantial profit! You do not want to purchase the painting right now, as you first want to research its market value and you also need more time to appraise the demand for it out there. In this case, you could go to this friend or neighbour and offer him $500 for an Option – for a “right” to buy the painting. His answer would probably be, “Well, okay, I will only let you have this right for one year, and you may exercise this right any time within the year – if however you do happen to exercise your right of purchase then this painting will cost you $17000” To clearly explain option trading, in this transaction, you are the buyer of the Option and your friend is the seller. You are purchasing a “Call” (the right to Purchase) Option on this painting with a time value of one year. For a “Call” to become profitable the buyer assumes the painting price will rise. The cost of the Option $500 is the “Premium” you pay for the right (but not the obligation) to purchase it. The price at which you are entitled to purchase this painting $17000 is the “Strike Price” of this “Call” Option.
Well, you would only exercise your right to purchase if the painting increased in value above $17000! If however it does not gain any value or loses value within the specified one year, you walk away and owe nothing – you are not obligated to buy it! You will have only lost your premium. As the buyer, your total risk is $500 - the Premium. You also have the potential for unlimited gain. If the painting rises in value to say $25000 you would gain $8000 on your $500 investment. As a seller, your neighbour can only gain $500 the premium he requests with the strike price. If the painting’s value rises, he stands to loose all that potential gain of prospective profits. This example is very similar to how Options work in the trading environment. One final word of caution, and that is European Options can not be exercised before their time value is up. American Options are much more flexible and you can exercise or trade them in anytime within their time value! Learn my simple trading strategies which are being introduced gradually in this web site using charts - apply this to trade Options!
So what is the difference between a Futures Contract and an Option?
Explain Option Trading to Home
|
Strike price is the price you will pay the seller of the Option, if you decide to exercise your right to purchase it before the one year is up – this option will cost you $17000…any rise in value above $17000 is your profit to keep!
