This is the second in a series of posts on options. This series will help you to understand options contracts, their strengths and weaknesses, and risks. Most importantly, this series will make you a more successful investor.
Click Here to start at the first post on options.
A Simple Example
An options contract is simply an agreement between two people. The best options contracts to enter are those which are mutually beneficial. Let’s take a look at this example.
Scenario, Mary and Joe
Mary holds 100 shares of Berkshire Hathaway (BRK.B). She bought these shares for $100 each. Now they are selling for $250 each. Mary is pleased with the increase in the value of her shares and she doesn’t want to sell them because she feels they will continue to increase in value. On the other hand, she wants to protect the profit that she’s made.
Joe would like to own Berkshire Hathaway shares, but he feels they are too expensive. He has calculated that he would like to buy Berkshire at $200 per share. He would also like to earn some money while he’s waiting for Berkshire to drop to his target place.
The Contract (Option)
Both Mary and Joe can fulfil their goals through a Put contract. Here’s how it works:
Mary buys a Put contract which stipulates she can choose to sell her shares of BRK.B at $200 by December 31st, no matter what the price of BRK.B is on that day.
Joe sells a Put contract which stipulates he must buy shares of BRK.B at $200 if Mary decides to sell them by December 31st, no matter what the price of BRK.B is on that day.
In order to complete the contract, Mary will pay Joe today. This is his premium.
Outcomes
This is a win-win. Mary has paid a small amount and has the peace of mind that she can sell her shares for $200 no matter how low they go (even to zero!). Joe is getting paid today to agree to do what he wanted to do anyway – buy Berkshire Hathaway for $200/share.
Of course, Mary would never choose to exercise this option if BRK.B does not fall below $200. In this case, the contract would expire at the end of trading on Dec. 31st. Mary would still have her shares. Joe would keep the premium he was paid – but still doesn’t own BRK.B.
On the other hand, say the price of BRK.B falls to $190 in November. Mary sees no sign of recovery, and she chooses to exercise the contract. She has Put the shares to Joe. Joe is now obligated to buy those shares at $200, even though he could have bought them for $190 on the open market. Remember, in exchange for this risk, he has already been paid a premium when the contract was opened. He also achieved his goal – he is now the owner of BRK.B which he was able to buy at $200.
There are similar scenarios for call options. See if you can come up with one which benefits both the buyer and seller! If you think of one, put it in the comments for us to discuss.
There are more terms to know when playing with options. We will go over them next time.
If you have any questions or comments about this material, please place it in the comment box below. I would love for these posts to be an interactive classroom for everyone.
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