An option is a contract that gives the buyer the option but not the obligation, to buy or sell an investment such as a stock at a certain price and on or before a certain date. And the buyer pays a price for the option.
The easiest example of how options work is with real estate. Let’s say you find a house but you won’t have the money to purchase it for six months. You enter into a contract with the owner that gives you have the option to purchase the house for $100,000; for that option you pay the owner $1,000. Two months later it might be discovered that the scribblings on the wall belong to Elvis and the house is now worth $1 million. The seller is obligated to sell you the house for $100,000. In the end you could net $899,000 from the transaction ($1,000,000 minus $100,000 minus $1,000). On the other hand, it could work out instead that a few months later the support beams give way, causing the house to slide down the hillside and come to rest on the highway below. In this case you would let the option expire and be out the $1,000.
With securities, option trading is more speculative and therefore riskier. You must guess correctly whether a stock is going to go up or down, when that’s going to happen, and the price of the stock. One of the appealing aspects of option trading is that you don’t necessarily have to own the stock, which means for very little money (the price of the option) you can control a block of stock. A small movement in the stock price could mean a large payoff – or a financial tsunami.
Options can be excellent risk management tool to protect investments and a way to make substantial profits with minimal money upfront, but like any other strategy, without proper research, knowledge, and monitoring they can be hazardous to your financial health – as Ned found out.
The goal here was to give the definition of options, a brief description how they work, and a word of caution. Option trading is complex, and it’s not for everyone. Ned thought he was ready for option trading after having traded stocks for a while and attending a workshop that sold trading software. He wasn’t. He didn’t practice long enough with imaginary money before making trades with real money. He didn’t study the markets long enough, didn’t watch his positions close enough. He had a job with long hours and a family. Maybe he thought it would be as easy for him as it was for the workshop facilitator who only spent a couple of hours a day on the computer making trades. It wasn’t.
There are many ways to make money. Trading options is one of them. Is it right for you? Only you can answer that. To learn more go to one of the discount brokerage firm websites such as Schwab.com or TDAmeritrade.com and check out their option trading tools and education.