Imagine you have a friend who wants to sell his house for $200,000. You are familiar with the subdivision, and you like the nearby golf course that makes the area desirable, but you don’t have the $200,000 to purchase the house as an investment, so you offer another proposal.
“If you’ll give me a piece of paper saying I can purchase your house for $200,000 any time over the next twelve months,” you say to your friend, “I will give you an extra $10,000.”
Your friend accepts your proposal because it’s not important to him that he sells today. In essence, you have bought an option – an option to purchase the house at a later, agreed-upon date.
Eight months later, a new elementary school is under construction a half-mile away, making the properties in the area in hot demand. Now the house has gone up in price to $230,000.
You hold up your paper—the option—and wave it in front of interested buyers. “I’ll sell you this paper for $15,000. It states that you can purchase this $230,000 house for only $200,000.”
Someone takes you up on your offer, and the trade is made.
Let’s break down what happened from here.
Your friend receives the $200,000 he wanted for his house, in addition to the $10,000 you paid for the option to purchase his property.
The new buyer purchases a house valued at $230,000 for $200,000, plus the$15,000 he paid you for the paper option. He pays a total of $215,000, a savings to him of $15,000.
And, you receive $15,000 for the option (paper) you paid $10,000 for eight months ago, so you made a $5,000 profit on your $10,000 investment. That means that you realized an astounding 50% return within eight months.
My story illustrates in a simple way the crux of the “secret” world of trading options. In the story, you see the house, the owner, and the buyer. They are all tangible to you.
In the world of Wall Street, it’s all like “invisible pieces of paper,” so to speak, especially when the transactions take place online. However, the principle is the same. You control enough of a great stock to make a great deal of money with essentially only a down payment.
Most of us can’t go out and simply plunk down $200,000 to invest in an “underlying instrument,” like a second house or a block of stocks. But you can benefit from the leverage of controlling the “underlying” with a fraction of the house or stock cost by using options.
The leverage of options allows you to profit by a substantial amount, in the same way a pulley leverages weight so you can lift more than physically possible. Options give you profit leverage that builds wealth.
You can achieve significant short-term profits on the money you invest in option contracts. You profit by purchasing option contracts, called Calls and Puts, with the express intention of selling the contract after the equity (the stock, ETF, or index,) has moved in price, either up as with Calls, or down as with Puts, and you sell well before the option’s expiration date. As with the house, you have the right to purchase the equity at the price you agreed upon in the options contract, but in fact you never intend to do so. Your profit is made on the price movement and exiting the contract before its expiration date.
When you purchase an unripe banana on the produce aisle of the grocery store, you know the banana still has a long time before it has to be eaten. In terms of options, the idea is to sell the banana before it becomes yellow with brown spots, soft and ready to expire.
By using this strategy, you never exercise your option to buy the underlying equity. Your goal is to hold the option long enough for the price of the equity to move in the direction that you predicted when you purchased the contract. You don’t intend to exercise the option (you never eat the banana), but someone else will want to make banana nut bread, so that now ripe banana you are holding has value to someone else that they are willing to pay for.