My Options Investing Metaphor (Or the Power of Leverage)
You are at a party and you meet a real-estate developer who is working on a 100 unit community, built from the ground up. He says there is a lot of interest in the development and you know the lot he is building on is in a "hot" real-estate area.
The next day you meet the developer at his sales office. You notice a lot of other people are looking into the development, as well. He shows you a scale model of community and walks you around the vacant property, pointing out the future location of living units, spa, shops, restaurants, etc. He says each unit will sell for $200,000 and construction of the community will be finished in 6 months.
It seems like a very exciting investment and you think the unit prices will jump when the community is complete. However, it is all "sight unseen" and you are concerned about what it will be like when the construction is complete.
What if you put up $200,000 and the bottom drops out of the real-estate market. Conceivably, you could lose it all as you are completely exposed to investment risk, while you wait for construction to be completed.
The developer sympathizes.
He says, "Would you be willing to reserve a spot for $3,000. If so, I promise to save a unit for you and sell it to you at $200K, at anytime before construction is complete. If you decide not to buy, you only lose the $3,000"
Well, you think the community is going to be a success and unit prices will go sky high. You also like the idea of investing a fraction of the asking price. Even if the real-estate market drops, you are only risking the $3,000. So, you pay him $3,000 for the right to buy one of the units for $200K within 6 months.
This Is a "Call" Option
(In a call option, you buy call options when you think the underlying asset – in this case real estate – will increase in value.) A call option gives the option purchaser the right, but not the obligation, to buy an asset for a predetermined price, within a limited period of time.
You are "buying" the right to purchase the unit for $200K, and it costs you $3,000.
The developer "sells" you this right to purchase the unit for $200K and he receives $3,000 for providing this right.
Now let’s apply the same idea to the Crude Oil market.
Let’s say it’s March and Crude Oil is currently trading at a price of $50/barrel.
You think Crude Oil prices will rally to $60/barrel over the next six months (to October).
However, you do not have a crystal ball and you do not know where prices will be in 6 months. You could lose a fortune if you just bought October Crude Oil futures and the bottom drops out of the Crude Oil market. You are completely exposed to investment risk.
Instead, you could purchase the right to buy October Crude Oil at $50/barrel for $3,000, for 6 months in the future.
The individual providing this right is obligated to sell you Crude Oil at $50/barrel, anytime you wish before the 6 month period. If you decide not to buy, you only lose the $3,000.
Buying this October Crude Oil $50 call option gives you the opportunity to invest in the Crude Oil market at a fraction of the margin price. In addition, if Crude Oil prices fall, you are only risking the $3,000.
Conversely, if prices rally, your potential gains are unlimited.
You are "buying" the right to purchase Crude Oil at $50/barrel and it costs you $3,000. The option "seller" is obligated to sell Crude Oil to you at $50/barrel. He receives $3,000 for providing this right.
This example still may be confusing to some. Again, I urge everyone to call RMB Group to get their free report, IPS Short Course to Futures and Options.
A division of Man Financial, the RMB Group has specialized in options since 1984.
They are highly regarded for their personal service and "big move" option strategies. In addition, they Auto Trade virtually all respected stock and commodity advisory services. Auto Trade means they automatically track and execute all buy/sell recommendations for you.
Arrangements have been made for Wealth Daily subscribers to receive a free copy of this report.
Call Sue Rutsen at (800) 831-3114 or (312) 528-3065.