How does the Options market work and can you use a lifelike example of a put / call position which is relatable?
In: Economics
Lets say Bob buys apples, and Sam sells apples.
The current price of apples on the market is $1 per apples, but if there’s a drought, there will be fewer apples, thus maybe apples will be worth $2 per apple.
So Bob wants to buy apples in four months. He could either just wait to buy them at that time, but he doesn’t know when the price will be. Bob thinks the price will go up to $1.25 per apple and he knows he’ll need apples. He calls sam, and he says hey, I’d like an buy a Call which gives me an option to buy 100 apples at a price of $1.10 per apple in four months. I’ll give you $5 as a premium for this deal.
Sam thinks to himself that this is a good deal. If apples are worth more than $1.10, he’ll still make $1.10 per apple, but if apples are less than $1.10, he’ll make $5 from the premium, and he’ll just sell his apples at market price.
Bob and Sam both feel like winners. Sam has made guarenteed money, and Bob isn’t at a risk of losing a bunch if he needs to buy apples when they’re more expensive.
Now we have Ted, who is an apple trader. Ted thinks that apples are going to go up to $1.25 per apple from their current $1 price. He makes the same deal with Sam, but Ted actually doesn’t care about owning apples. He spends $5 and now has a right to buy 100 apples at $1.10 per apple. Ted wants the price of apples to go up so he can use this call option to buy $100 apples for $110 , but immediately sell them for $125. He’ll make a $10 profit after his $5 premium. If he was really lucky, and apples were worth $2 per apple, he would make $85 from his $5 premium.
Now if you want to understand the options market, replace apples with stocks. Options allow you to set a future price you have the right to buy a security for at that price. It’s good for the seller because they reduce risk and gain a premium. Its good for the buyer because they reduce risk but lose a premium. It’s good for a trader because they can make large amounts of money with a smaller gamble. In the end, everyone has a reason to get involved, just not everyone wins.
Puts are a little harder to understand. They’re a bet that the price of the commodity or security will go down.
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