An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at a specified price on or before a particular date. An option is like any other financial instrument in that it is a binding contract with stringently defined terms and details. Options are used to gain exposure to an underlying financial instrument (say Google shares) for a fraction of the cost.
Using a real life example, let's say I have a camera valued at $100 that you think will increase in value in the future. You enter into a contact with me to buy the camera in 6 months time for $100 and in return for selling you this option I receive $5 from you today (this is the option premium). Now, let's say that in 6 months time the camera is valued at $200, with your option you can buy my camera for $100 and then sell it to another party for $200. Your cost would be $105 ($100 purchase price + $5 premium), giving you a net gain of $95. I would receive a total of $105.
Looking at it another way, the camera could be worth $50 at the end of the 6 months. What would happen to your option in this scenario? You would not want to purchase a $50 camera for $100 so your option would expire worthless and you would be lose your $5. But, you are still in a better situation than if you had bought the camera 6 months ago for $100. I still own the watch, which has reduced in value by $50, but I also get to hold on to the $5 option premium so my actual loss is $45.
This is how the options market works. You have a buyer who pays a premium to the option seller and will make money if the underlying security increases in value. The seller receives the premium but gives up any future price gains. This type of option is called a call option, which is the right to buy an instrument. The other type of option is called a put option and works in the opposite way in that it is the right to sell an instrument. You would buy a put option if you believed the price of the camera was going to fall.
For more details, please visit Options Trading IQ
Using a real life example, let's say I have a camera valued at $100 that you think will increase in value in the future. You enter into a contact with me to buy the camera in 6 months time for $100 and in return for selling you this option I receive $5 from you today (this is the option premium). Now, let's say that in 6 months time the camera is valued at $200, with your option you can buy my camera for $100 and then sell it to another party for $200. Your cost would be $105 ($100 purchase price + $5 premium), giving you a net gain of $95. I would receive a total of $105.
Looking at it another way, the camera could be worth $50 at the end of the 6 months. What would happen to your option in this scenario? You would not want to purchase a $50 camera for $100 so your option would expire worthless and you would be lose your $5. But, you are still in a better situation than if you had bought the camera 6 months ago for $100. I still own the watch, which has reduced in value by $50, but I also get to hold on to the $5 option premium so my actual loss is $45.
This is how the options market works. You have a buyer who pays a premium to the option seller and will make money if the underlying security increases in value. The seller receives the premium but gives up any future price gains. This type of option is called a call option, which is the right to buy an instrument. The other type of option is called a put option and works in the opposite way in that it is the right to sell an instrument. You would buy a put option if you believed the price of the camera was going to fall.
For more details, please visit Options Trading IQ
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