Eli5: what is a buy and sell option trade, could anyone explain this clearly?


Eli5: what is a buy and sell option trade, could anyone explain this clearly?

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If you buy an option, you pay some money now so that at a later date, you alone can decide to buy the item in question for the price agreed upon at the time the option was sold. This can be used for speculation as well as hedging against speculation/price variations.

Say, I run a company that produces fries. I need potatoes regularly, but the local farmers have not yet brought in this year’s harvest. I know I want some of that harvest when it arrives, and I want to pay at most price X. So I find a farmer who sells me options on his harvest: I pay him some money now, and when the time comes, I can choose to buy those potatoes for the agreed-upon price (the farmer can not legally stop me) or, if the market price is lower, shop on the open market.

Like all deals, this has a number of (potential) consequences. If the harvest fails, the farmer is in deep trouble (he needs to buy those potatoes off the open market so he can fulfill his obligation to me). If the price is low, I’ve wasted the money I spent on the options (the farmer gets free money, which somewhat offsets the low price he gets for his produce on the open market.)

A sell option works basically the same, just the person with the goods calls the shots instead of the person with the money.

Now, most people will encounter option trading in the context of stock speculation. It works basically the same, except it’s not about necessities (the aforementioned farmer needs to sell his potatoes, the company needs to purchase them, and both want the price to stay in the reasonable range) but speculation. if you outright buy stocks, you need a large investment and are then linked to the stock price, which will typically vary not that much. Even if it drops, only part of your money is gone, if it rises, it rarely does more than a few dozen % within short time frames.

Options are cheap, however. So, if you buy options for little inital investment and the stock price rises, you can buy stocks under value, resell them straight away, free up your capital and pocket the win. However, if the stock price falls even a little bit, your entire initial investment is gone, as pulling that option when you can buy the stocks on the open market for a lower price makes no sense.

If you follow r/wallstreetbets you’ll see it’s actually an option to lose your life savings and home.

An option is a contract you pay for to buy a share at a future time.

Apple is (imagine) $10 today. You want to make a contract with me to buy an Apple share at $10 on Monday.

Not a problem, I wasn’t selling anyway. Give me $1 and I’ll give you that contract. Now I buy another Apple share at $10. Come Monday, when I sell you the share for $10, it doesn’t matter what happened to the price, I’ve got the same number of shares and made $1 by selling the contract.

You’re betting on the market. If Monday comes and Apple is $20, I have to sell to you for $10 per the contract. It cost you $1 for the contract so you’ve made $9.

Great, but why not just buy the share at $10 in the first place?

Well, you only have $10. What you’re going to do is buy 10 option contracts for $10. Now come Monday your $10 investment is worth $200.

But you’ve spent your $10, how do you buy those shares you’ve committed to buying?

Well don’t. Just sell the contracts. The contracts are now worth $200, someone will buy them for just under $200 and make a bit of low risk profit.

Ok Great, so you bought those 10 options but now Apple is worth $5 on Monday. You need to pay me $100 for those shares today and nobody will buy your contracts for more than they’re worth. You can sell them for near $50, but you also just spent your last $10 last week to get those contracts. Uh oh. You’re in trouble now.

The true ELI5 answer is that it the answer is entirely in the name: OPTION. Options are contracts where the person paying for the contract has the OPTION of executing the contract (to buy or sell something) prior to the option expiration (options have a date in the future when the contract ends – the buyer can’t exercise their OPTION after that date). The buyer can choose whether or not they want to execute the contract – it is their OPTION.

Options are when you buy *the option* to buy or sell a stock at a predetermined price.

Say a stock is $50 I can buy an option saying I reserve the right to buy this stock at $50.

If the stock price goes up to $60, then I can exercise my option and buy the stock for $50 and immediately turn around and sell it for $60 meaning a $10 profit.

Now you might have noticed that I could have also bought the stock at $50 when I bought the option and then sold it for $60 when it hit $60 and also made $10. The difference is that the option didn’t cost $50.

The option probably cost around $2.50. what this means is I could buy 20 options with the same $50. And if it goes up to $60 I don’t make $10, I make $200 on that $50 investment.

So rather than spending $50 to make $60, with options you can spend $50 to make $200 with the same amount of movement of the stock price.

There is a big problem though. What if the stock price goes down?

Well if you bought a $50 stock and it went down to $45, you lose $5. But if you bought your options to buy at $50, and the price goes down to $45 then you just lost **all** your money. Because you paid $50 to buy 20 shares at $50. But the shares aren’t worth 50 so if you exercise your shares you actually increase your losses.

So if the share price doesn’t go the direction you bet that it will go, you lose *all* your money.

But it gets worse because to make money the share price has to increase by MORE than what you paid for the option. If you pay $2.50 for the option but the share price only goes to $52.00 then you still lose $0.50 per option. You don’t lose all your money this way, but you still lose money.

The stock price would have to go up to $52.50 to break even, where you don’t gain or lose money. But then for every $1 above that you’re actually making $20.

So it’s a high risk high reward. If you’re right your earnings are exponentially higher. If you’re wrong you lose everything.

One person buys the option and the other person sells. It’s a zero sum game. If you buy an option there is someone literally on the other side selling. It’s no different than the futures market when betting on commodity prices.