It's not like you can go down the street and ask your neighbor to explain option trading to you. They may understand stocks or mutual funds, but few people understand options trading.
The so called "gurus" will gladly explain it to you, if you pay them thousands of dollars up front. My experience tells me that the options trading community is a very tight lipped community with a high price of admission. This is why few people ever learn how to trade, or know about stock options trading.
I have to tell you that yes, I did pay that kind of money to learn how to trade and yes, it was worth it, but my opinion still remains the same about learning. You shouldn't have to pay for the basics!
In this lesson I'll not only explain option trading, but also show you how profitable it can be.
Option Trading
The first way I'd like to explain option trading is in terms of what I do on a day to day basis. I'm an option trader and I trade stock options. As an option trader I'm essentially in the business of buying and selling contracts.
"Real estate investors" buy and sell homes. "Option traders" buy and sell contracts.
The contracts are stock option contracts, but don't be too concerned with the type of contracts. Just remember this simple definition: Options Trading is the business of buying and selling contracts.
Contracts? Yes contracts. You know, like the contract you sign to buy a house, or a contract you have with a lawyer or musician.
Contract: an agreement made between two or more parties.
I could explain option trading with the dictionary definitions of stock options, and options trading, but that would bore you. Besides, I'm sure you didn't come here for that. You most likely came here for someone to explain option trading in an easy-to-understand manner.
Now bear with me for a moment as I explain option trading in a way that has nothing to do with the stock market. This will help some people understand how buying and selling contracts can be so profitable.
Options Trading Example
Let's say you find an undeveloped piece of land that you believe will increase in value over the next few years. You don't want to buy it outright, but you would like to tie up the land with a contract that gives you the right to buy the land if you so choose to.
The land is in the middle of nowhere, surrounded by 20 miles of forest on each side. You have it appraised and find out it's worth $25,000. You approach the owner and ask him/her can they draw up a contract with a time period of 3 years that will allow you the right to buy the land any time during those 3 years for a set price of $25,000.
Remember this is what the land is worth right now. There's nothing around it and its just boring, raw, undeveloped land. You pay him $2,000 for the rights of this contract.
You're not obligated to buy the land, you've just purchased the right to buy it. If you decide not to purchase the land your contract will expire, and you'll lose your $2,000.
You Hit the Jackpot!
Time goes by and two years later the city has built a new mall 15 few miles down the road. New housing developments have gone up and to top it off Wal-mart builds a super center right next to the lot that you have the contract for. This is now a prime real estate location.
Remember you have the right but not the obligation to purchase that lot next door for $25,000 AND you only paid $2,000 for the contract.
Now let's use a bit of common sense. Two years ago the land was only worth $25,000 because nothing was built around it. Do you think the land is worth more now that there are malls, housing developments, and Wal-mart next door?
Yeah, you bet your bottom that lot is worth more than $25,000. For exaggeration purposes lets say the lot is now worth $100,000. You're a happy camper! You own a contract that says you get to buy that land for only $25,000. So if you wanted the land you could exercise your contract and purchase the land for $25,000.
You would then be the proud owner of a $100,000 piece of real estate that only cost you $25,000. You could keep it, or sell it on the open market and pocket the difference between what you sold it for and what you paid for it ($73,000 or 270% return on investment).
Or you have another option. You could take the approach of an option trader. You could take that contract and sell it to someone else.
Remember you paid $2,000 for the contract. You now own a contract that says you have the right to buy a $100,000 piece of land for only $25,000. Do you think someone might be willing to pay you more than $2,000 to own that contract?
Yes any person in their right mind would.
Time to Make Some Money
You decide that you don't want to own land and you'd rather sell your contract to someone else. You sell your contract to a local land developer for $20,000 and you walk away happy because you just made an easy $18,000 dollars or a 900% return on your money.
So now you have an example of how buying and selling a contract can be profitable. It's also probably one of the easiest ways to explain option trading because as an option trader, buying and selling contracts is what you'll be doing.
**Tip** Do not dig deeper into the example. A lot of people try to figure out why a person would let someone tie up their land. Others want to know why the person who bought the contract didn't just buy the land. Keep your thinking on the surface level. Buying a contract and selling it at a higher price.
Here's the lesson: As a stock option trader you're going to invest a relatively small sum of money to buy a "contract" that controls something larger. Your research tells you that your contract will increase in value before a certain date. When it does increase in value, you're going to sell the contract for a higher price than you paid for it and pocket the difference.
