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.
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