As part of your introduction to Wealth Daily, you'll be receiving a multi-level education in beginner options over the next few days. Today is Lesson 1.
Essentially, options are just another way to invest in stocks. It's not quite as direct as just buying a stock, but the beauty is they give you more flexibility and choice over cost and timing. More on that later...
Simply put, a stock option is a contract that gives an investor the right (but not the obligation) to buy or sell shares of an underlying stock at a set price on or before a set date.
Say you're at a party and meet a real estate developer who is working on a 100-unit community, built from the ground up. He says there's a lot of interest in the development and you know the lot he's 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, spas, shops, restaurants, etc. He says each unit will sell for $200,000 and construction of the community will be finished in six months.
It seems like a very exciting investment and you think the unit prices will be much more expensive when the community is complete. However, it's all "sight unseen" at this point.
What if you put up $200,000 to buy it and the bottom drops out of the real estate market? 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 you do, he promises to save a unit for you and sell it to you at $200K anytime before construction is complete — even the very last day. If you decide not to buy, you only lose the $3,000.
You like being able to choose whether or not to buy the condo whenever you want. Since you only have to put down $3,000 and have locked in a purchase price, you could make a killing if the market looks rosy as construction completion nears.
And if the bottom does drop out, you risk only $3,000 instead of the full $200,000.
So you pay him $3,000 for the right to buy one of the units for $200,000 by a certain date — in this case the contract is for six months.
Stock options work the exact same way: buying an option contract gives you the right to buy or sell a stock by a certain date.
They can work whether the stock goes up or down. And you choose how many shares you'd like the right to buy or sell. We'll cover how both those things work tomorrow in the next lesson.
Options Coach, Wealth Daily