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OPTIONS BASICS - AN INTRODUCTIONOptions are unique in terms of an investment vehicle because of their flexibility and versatility. Stocks, or even futures are nice because they are highly structured instruments, but that same rigidity can sometimes make it difficult to execute a strategy that you think is best suited to the situation. Options on the other hand can be as conservative or speculative as you desire. For example, there are options strategies that benefit even if the market does not go in the direction you sought. In essence, some of these strategies are hedged.
However, the high amount of versatility does not mean there is an absence of risk. In fact options can be quite complex and as such involve substantial risk and thus are not suitable for all investors.
Options are a multi-faceted investment with many plusses and minuses.risks and rewards. The purpose of this tutorial is to introduce you to some of the basics of options and provide a first step in your education. Should you wish to continue we encourage you to learn and understand as much as possible before investing. Like any investment, the more you know, the better your chances for success.
WHAT ARE OPTIONS?An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset such as a futures contract at a specific price on or before a certain date. An option, just like a stock or futures contract, is an exchange-traded security. It is also a binding contract with strictly defined terms and properties.
Options can be complex, but let's look at the concept of an option put into another context to better help explain how they work. For example, say that you found a plot of land that you wished to purchase but you won't have the cash to buy it for another three months. You could negotiate with the owner of the land to buy an option on the land that would give you the right to purchase the $100,000 piece of land in three months time. For that right, you would pay the landowner $1000.
Now the versatility of options comes into play. Here are a couple of possible future outcomes from the purchase of your option:
1. During the three-month time you own the option, a land developer comes in and is building homes and a shopping center adjacent to your plot of land. This development would now make the value of your plot of land double overnight! Because the owner of the land sold you the option, he is obligated to sell it to you at the agreed upon price of $100,000, even though it is now worth $200,000. Therefore, you stand to make $99,000. ($200,000 new property value - $100,000 original price - $1000 cost of the option)
2. You had intended to buy the land and build a house, but during the three-month period you held the option you find out they will be building a freeway right across the street. Since you only have the right and not the obligation to purchase the land you elect to not exercise the purchase option. You did lose the $1000 you paid for the option, but you are not obligated to buy the land.Again, options provide needed versatility in investing. As the example illustrated, there is risk and you can lose the 100% of your investment, the money used to pay for the option. The option is simply a contract that applies to the underlying asset and is therefore called a derivative because it derives its value from something else. That underlying asset is a stock or a futures contract.
Calls and PutsThe two types of options are calls and puts:
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a futures contract. Buyers of calls hope that the futures contract will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a futures contract. Buyers of puts hope that the price of the futures contract will fall before the option expires.
Participants in the Options MarketThere are four types of participants in options markets depending on the position they take:
1. Buyers of calls2. Sellers of calls3. Buyers of puts4. Sellers of puts
People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to h... [download for more]
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