Options explained

There are many things that somebody could invest in. You could invest in stocks, bonds, mutual funds,etc.  Some of the best investment vehicles, such as futures and options are the ones that many traders fear and don't really understand. Options are derivatives that derive their value from an underlying asset. This means that the price of an options contract is based on something. This something can be a stock, commodity, etc.  Options  are probably one of the most complicated things to understand for novice investors

An option contract is a contract in which the holder or buyer of the contract has the right,  but not the obligation to exercise the contract. The seller or writer of an options contract is obliged to do his or her part if the buyer or holder of the options contract chooses to exercise it. An options contract usually controls 100 share. There are two versions of options: put options and call options. If you buy a put option, you have the right to sell 100 shares of a stock at the specified strike price at or before the expiry date of the option.  If you buy a call option, you have the right to buy 100 share of stock at the specified strike price at or before expiration. I have said" at or before" because there are two categories of options: American and European. American options can be exercised any time between the current date and the expiry date. European options can only be exercised on the expiry date.  The strike price is like the fixed price that has already been set. Let me talk about an example:

Lets say that Sally is confident that a stock is about to go up, but does not have a bunch of money to invest. She buys a call option for $200. The actual price is actually is $2 but since the option contract controls 100 shares, she has to pay $200( 2*100).   The strike price is $50 and the current price of the stock is $45. So as you can see Sally controls 100 shares with an options contract with a premium of $200; the premium is the fee you have to pay to the seller to buy the options contract. Sally controls 100 share with $200 rather than spending $4500 buy actually buying the stocks. Lets say that the stock goes up to $60. Sally already has an call option with a strike price of $50. She exercises it and buys the 100 shares for $5,000 and sells them for $6000. As you can see Sally has made a $1,000 profit (6,000-5,000). That is not really the profit because she had paid a $200 premium when she had bough the contract. So her real profit is only $800 which is 4 times the initial investment of $200, a 300% increase. Lets calculate the profit made if she actually bought the shares. The profit would be $1500 because she bought for $45*100 and sold for $60*100, this is only a 33.33% increase.  Lets say the stock plummets to $30. Since Sally has bought an option contact which gives her the right to not exercise the contract, she only loses $200. If she had bought the shares, she would have lost $1500.  This example obviously excludes all the the commissions and fees that would have been taken into account if this was a real transaction, but since this is only for explaining purposes, it is is sufficient.

Options are great for increasing leverage and reducing risk, as you can see. There are always two sides to an option. Somebody wins and the somebody else loses. Options prices fluctuate when the underlying asset goes up and down. Most option contracts aren't really exercised. They are sold for a higher premium  than they were bought at. The premium of an option is determined by its intrinsic value plus its time value. The intrinsic value is the amount the option is in the money. In the money can be two different things. For call options, in the money is when the stock price is higher than its strike price. So for the example above, the intrinsic value would be $10 because the the stock price is $60 and the strike is $50.  Time value or extrinsic value is option price- intrinsic value. So if the current price of Sally's option was $10.xx and its intrinsic value is $10 so the time value would be about $0.xx  The real calculations for determining the time value of an option are fairly complex. Time value decreases as the option gets deeper "in the money", meaning that you would profit by selling the options contract.  If a call option is out of the money, then its intrinsic value is zero. The option will slowly keep losing its value and will be worth zero by the expiry date.

Put options work a bit differently. Put options are in the money when the stock price is below the strike price. This is because buying put options means that you think the stock will go down.For example, lets say  you bought a put for $500. The strike price was $60 and now the stock is trading at $40. This means that you have an intrinsic value of $20(60-40) The option would be now worth about  $20.xx and you would make a good profit selling it. The profit would be 20-5= 15 times 100 which is a $1500 profit, a 200% gain on your investment.

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