What Are Options

We'll begin our tutorial by understanding the fundamental concept of what are options. Options are the right – but not the obligation – to buy or sell a futures contract (or any other asset) at a specified price at any time prior to a specified date.

Let’s say that it is now the month of July, and that you’ve just learned that your neighbor wants to sell his fantastic twin-engine snow blower that he’s got stored away in his garage. He wants $1,000 for it, and would like to  have it sold by January 15th. You’d like to have it, but unfortunately you don’t have the money to buy it right now. Yet, you’re convinced it’s going to be a snowy winter and the snow blower is going to be worth a lot more than $1,000 by January. So you and your neighbor agree on an OPTION. Whereby, you have the RIGHT (but not the obligation) to BUY his snow blower for the SPECIFIED amount of $1,000, on or before the SPECIFIED date of January 15th. However, to grant you this right, your neighbor required that you put up front $100. And of course, as the seller of the option, your neighbor gets to keep the $100 even if you ultimately decide to pass on the snow blower.

The above simple-minded illustration, manages to cover some of the important components of an option which we’ll be dealing with throughout this tutorial. We have the underlying asset (the snow blower), the strike price ($1,000), the premium ($100), and the expiration date (January 15th.).

Let’s look at another example, only this time using real estate and with a slightly different angle. You’ll notice that the same basic option components will all still be present throughout this next example.

Say there’s a vacant lot in your neighborhood worth about $100,000. Because of improvements in the area, you have reason to believe that this same lot will be worth much more than $100,000 in one year. So you go to the owner of the vacant lot and offer her an OPTION. You want the RIGHT (but not the obligation) to buy her land anytime between now and the next 12 months, for the SPECIFIED price of $115,000. In order to grant you this option, she requires a PREMIUM (up front deposit) of $8,000. She’ll keep the $8,000 whether you buy the land or not.

Why does the landowner require this premium? Simply because it’s the landowner that carries the greatest financial risk during the next 12 months. Suppose a property investment company comes along and wants to build a mall right next to this vacant lot, and would like to use the lot for additional parking. They offer the lot owner $300,000 for it. However, she’s not free to sell it to them over the next 12 months, because she has the obligation to sell it to you for $115,000 anytime over the next 12 months. When the investment company contacts you with the offer, you EXERCISE your RIGHT to buy the lot at the SPECIFIED price of $115,000, and then turn around and sell it to the property investment company for $300,000. In other words, you’ve just made $185,000 profit on an $8,000 investment. 

On the other hand, what would happen if the opposite occurs? Suppose that instead of a mall they build a lovely toxic waste dump right next to the land. The value of the lot will probably decrease. The owner comes to you and asks if you would like to exercise your right to buy the lot now. You answer “I might be slow, but I’m not stupid. I do not wish to exercise my option!” So after the 12-month period, you lose the $8,000 premium you put up for the option, but at least you’re not stuck with a worthless piece of land.

At this point, you’re probably figuring that as an option buyer you stand to make a lot of money when things go your way, and only lose a little money when things don’t go your way. This is true. The question is, however, how often will things go your way and how often will they not.

In the same manner, you’re probably figuring that as an option seller, even though you keep the premium, you potentially stand to lose a lot of money if the asset you own greatly increases in value. This is also true. However, the key here is what are the odds that your asset will increase or decrease so substantially in value within a defined period of time. Think about it for a moment, how many times would your vacant lot increase three times its value because it happens to be next to a future mall they’re building? Or tumble in value because it’s next to a future toxic waste dump? It’s not an everyday event is it? Chances are, over the next 12 months this vacant lot would have increased or decreased in value only a reasonable amount. Perhaps not even enough for the option buyer to exercise his right.

In other words, the option seller from our previous real estate example just made $8,000 for simply granting you the right to do something that was unlikely to happen. This is why it is often said that selling options, while carrying more risks, allows you to create a stream of income.

Next: Options Terminology