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What Is Options Trading?

Here's a real world analogy that describes an options contract: let's look at the home buying process as a way to explain options trading. I'm looking to buy a house. It is my dream home and I can't imagine finding any other place that will measure up to it. A hot tub, a sun room, basketball court, and did I mention the ocean view? This house is going to sell fast, but there's a problem. I don't want to get a mortgage because I know that in only 3 months, after I finish a large job and get into some money, I'll have the final $20,000 needed to buy the house in cash. Now you see the problem: I don't have the money now and in 3 months I suspect that the house will be sold and off the market. So I ask the home seller to enter into an options contract with me.

I go to the owner to strike a deal. I tell him that if he will take the house off of the market, I will pay him $3,000 right now and in exactly 3 months I can buy the house from him for $300,000, or walk away. (I'm slightly concerned that my large job won't be done in 3 months.) If I walk away, he keeps my $3,000. If I buy, I give him the $300,000.

Two things could happen with my options contract: what if in month 2, a disaster happens and the beautiful ocean view ends up being marred by a hurricane - a large one, in fact. This disaster inflicts $100,000 worth of damage to the house and the beach will take years to clean up. So my $300,000 dream home is now a nightmare and I no longer want it. The great news is that I let the 3 months go by and all I'm out is the $3,000 I gave the seller to reserve the house for me.

The other thing that could happen is great news: suppose in month 2, it so happens that some people find the rumored fourth ship from Christopher Columbus' fleet when he discovered the new world. And guess where it was? Yes, in my backyard right there on that beach. The Discovery Channel wants to pay "the owner" of the property $1 million dollars to dig up that ship. Of course the original owner wants to pocket the money but the great news is that because the owner and I already have an options contract, I actually have the rights to that property. Guess who is going out for a fancy dinner tonight?

Sadly, my story is fictional but if you understand it, you know how an options contract works. Of course Christopher Columbus and hurricanes probably aren't going to affect options contracts in the real world but at its most basic sense, an options contract is simple. You have the right but not the obligation to buy something. In your first options contract you will probably be dealing with stocks.

It took me a little while to get this all straight in my mind so I will give you a little time to think about it and do a little reading on your own.