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