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Explain options to me as if I were a child!

Discussion in 'Educational videos and material' started by StockJock-e, May 18, 2016.

  1. StockJock-e

    StockJock-e Brew Master
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    Options are often misunderstood, they can be the riskiest of vehicles, or the best thing you can ever do to hedge your porfolio!

    There was a great question and answer on r/investing (by u/Skurry) which nails the definition in a way we can all understand! :D

    Call options:

    Ted is visiting Jimmy and notices a nice baseball card.

    Ted: "That's a nice baseball card! What is it worth?"

    Jimmy: "About $10 right now!"

    Ted: "Dude, I bet it's gonna be worth $20 by the end of the year!"

    Jimmy: "Really? I don't think so. Wanna buy it from me?"

    Ted: "Yes, but I don't have $10 right now. All I got is this one dollar bill."

    Jimmy: "Tell you what: I'll take that $1, and from now on until the end of the year, I'll sell you that card for $10. Just hit me up whenever you get the money."

    Jimmy just wrote a call option for $1 at a $10 strike price to Ted.

    Months go by. Ted just can't get that $10 together to buy the card. He notices the card's value is now up to $15. He tells his brother: "Hey, so Jimmy is gonna sell me that baseball card for $10, but it's now worth $15, and still going up. Thing is, I don't have the money to buy it. Can you give me $5.50 (since the call is now $5 "in the money" and guaranteed to be worth at least that much, but the card's value can still go higher), and I'll sell you that option?" So his brother gives him $5.50. Ted bought a call at $1, and sold it at $5.50, for a cool 450% return, without ever touching the card itself and risking very little money.

    By December, the card is now worth $18. On New Year's Eve, Ted's brother stops by Jimmy's house, hands him $10, then drives to the card shop and sells the card for $18. He executes the option, for a gain of $18 - $10 - $5.50 = $2.50, still a 45% return on his $5.50 investment.

    Jimmy is kicking himself in the butt, because he didn't believe that his card had that much potential. But at least he got a dollar "profit" out of the deal, without even doing anything. If the price of the card had stayed at $10 or below, he would have kept the card, and the $1 Ted gave him.


    Put options:

    Put option edition:

    Ted is visiting Jimmy and notices a nice baseball card.

    Ted: "Woah, I need this for my collection! Are you selling it? I'll give you $10 for it!"

    Jimmy: "Yeah, I'm not really attached to it and would totally sell it, but it's worth $20 right now. And I don't wanna get shortchanged, you know."

    Ted: "$20? That's nuts! It's worth $10, max!"

    Jimmy: "You might get lucky soon. I heard rumors that they're reprinting it, and then it'll drop to basically zero. I'm actually a little worried about this, but not worried enough to sell it for $10."

    Ted: "No way that they're gonna reprint this! Even if they do, it's not gonna drop much below $10. Let's do this then: Until the end of the year, you can call me anytime, and I'll buy the card from you for $10, no matter what it's worth. But in return, you give me $1 now up front, to compensate for the risk I'm taking on and because I need to keep the $10 handy. But if I don't get a call from you when the year is over, I'm gonna keep that dollar."

    Ted just wrote a put option, strike price $10, and sold it to Jimmy for $1. Jimmy is happy, because even if the card is being reprinted, he still gets $10 for his card, guaranteed. He basically bought insurance against the price drop. Ted is happy, because he got a "free" dollar, and he may get the card for $10, the price he was initially willing to pay anyway.
     
  2. B Russ

    B Russ Active Member

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    Haha. The puts still seem mind boggling, reading it as explained to a child. Not sure there is an easy way to explain those suckers.
     
  3. fireopal

    fireopal Well-Known Member

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    @B Russ Good find - didn't even know this was here but haven't ventured that much out of daily thread either so... And StockJock i must be an infant & will have to read this a few times - get some of it but not all of it.

    Ok have read just the call part a couple times now & still don't get what happened with the $9 strike price that was owed & will see if i can find one those dummy books.
     
    #3 fireopal, Sep 27, 2017
    Last edited: Sep 27, 2017
  4. B Russ

    B Russ Active Member

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    Im thinking i may open some more conversation, or at least threads on this. Jocks example was just one of the many ways to use options. And its only scratching the surface....or guess just add to this one.
     
  5. B Russ

    B Russ Active Member

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    @fireopal
    Ted wants the "option" to buy the card for $10 anytime he decides to within the yr. So Ted and Jimmy entered a "contract" saying he can. Ted pays jimmy a "Premium" of $1, to have the option to do so.

    As the "seller", that is Jimmy's dollar now. He can do as he wishes with it. Consider it payment for assuming the risk of having to sell it for $10, even if the value shoots to $30. If it dropped to $5, he pockets the $1 and gets to keep the card, because Ted wouldnt want to pay $10 more for a now $5 card.

    Now for Ted's motivation. Lets say 6 months go by. And the card doubled in value to $20. Remember he is still only out his $1. He can "sell" his option to buy it for only $10 to anyone else that wants it. But there is now $10 of value added to that contract. That being the real time value of the card, above and beyond the agreed purchase price. Maybe Johnny at the card store thinks it goes to $30, so he buys the option from ted for $10 "in the money" real value. + say, 50 cents since for time value, since 6 months have passed.

    Ted doesnt care about "exercising" his option anymore. He is 100% removed from that contract and made 1000% return on his $1 investment.

    Only in stock options, you may pay anywhere from $1 to $10 for a stock worth maybe $100 per share. But a contract is for 100 shares at a time. So if that were a stock example, u could pretend there were 100 of the same card in play, and he paid $1 per card for 100 cards.
    $100 that went up 10 times in value.
     
    fireopal likes this.
  6. fireopal

    fireopal Well-Known Member

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    @B Russ Ok so if the value of the card goes to $20 then Ted keeps $11. and gives Jimmy the $9. he is owed?
     
  7. B Russ

    B Russ Active Member

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    Close. Ted gives Jimmy $10. The initial $1 he gave was not a down payment. It was a fee, if you will, to have the option to buy it for $10. So when the card is worth $10 its considered in the money, or "ITM" but teds break even price is actually $11.

    That said, options are generally like playing hot potato. You never want to be the one holding it when they expire.

    But i still have yet to talk about them being used as a hedge. Its (in my opinion) important that anyone understands the basics before itegrating them. But selling "covered calls" is the strategy.
     
    T0rm3nted and fireopal like this.
  8. fireopal

    fireopal Well-Known Member

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    ^^ Friend switched from stocks to just playing options & he made it clear to me that the learning curve is not easy - takes much time & that no one should mess with options until they know exactly what they are doing, which i don't. Very confusing but want to learn more about them b/c friend also said what you said in that it is a good way to hedge. Just started playing that other direction (short) maybe 2 months ago which took me years to work up the courage to do so probably should work on mastering that one b/f i take on learning how to speak Greek!
     
  9. B Russ

    B Russ Active Member

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    well if you get shorting mastered, you are halfway through one side of the options chain ;)
     
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  10. SammyN

    SammyN New Member

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    What are the differences/benefits of buying and selling regular stocks vs options If it’s not for the long run?
     
  11. B Russ

    B Russ Active Member

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    Lets look at FB for example. It closed today at $170.87. Up $2.14. Lets say you have only 2k to invest. Buying the stock, you could get 11 shares. Todays profit $23 or so.

    That same 2k could afford you 6 $170 october expiry contracts at $3.25 per contract. A contract controls 100 shares. So you are controlling 600. Leveraging your money. At market close today, the same option contract was $3.75. 50 cent profit. Doesnt sound like much but that is per share. So you profited $300.

    Cons. If the shares move against you, you losses accumulate just as fast as profit if you are not hedged.

    They expire. And as expiry approaches, the time value decays. If you are in thr money, its no biggie. Out of the money and it will eventually become worthless.

    Those are some of the biggest pros and cons as i see it.
     
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  12. OldFart

    OldFart Well-Known Member

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    You beat me to it!
    Lol
     
  13. B Russ

    B Russ Active Member

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    hey old fart! good to see you still around! I took a hiatus but we BS'd and talked shop a bit in the old forum.
     
    OldFart likes this.
  14. OldFart

    OldFart Well-Known Member

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    good to see you here as well...I hope you are doing good!
     
  15. SammyN

    SammyN New Member

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    Well explained.
    Now let’s say I want to buy an option on a stock that’s $28 for example and I think it will be $30 in a month. Would I wait to buy the contract on a pullback to get a good price? How would I determine what’s a good price so that I could make a decent profit if it hits the $30?
     
  16. SammyN

    SammyN New Member

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    I bought around 150 shares of MU today at around $40.20. What would’ve been the move to do with options to turn that into a bigger profit?
     
  17. B Russ

    B Russ Active Member

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    Damn! MU has been on a tear, this quarter!

    So the short answer to your hypothetical stock is probably not so short. Lol. Options expire. One of the biggest factors in a contract price is IV, or implied volotility. TSLA is one of the most volitile stocks i know. Therefore, its NOV prices will be more than a slower moving stock with the same price per share.

    The right option in my opinion is also relative to your risk tolerance. ITM contracts have intrinsic value already priced in. Its safer. If stock moves against you, the option retains more value than say an option that was already 3 strikes OTM. But when stock moves with you, since you paid more for the ITM contract, the gains do not compound as much either.

    My personal preferance is usually the first strike in the money, to maybe 2 strikes out of the money. And i like them to have about a month before they expire. Any more than 2 strikes OTM and you are risking the stock never getting to that target. Or if it does, it takes so long, that time decay has eaten into much of your potential profits.

    I like a month or just under because i am not paying an arm and a leg for the time value, but it also gives me enough time to be right. Or if i am wrong, get out with a little skin left.

    I think that generically answers your MU question too. I know nothing about that company. I would hate to give you advice on how to play it. And because of that, i personally would be scared to play options on it. Just because it is at an all time high and i have nothing to backtest on, or see a pattern on.
     
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  18. B Russ

    B Russ Active Member

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    Oh and to the pullback. If you are expecting one, sure! Or if you are feeling really froggy, buy some puts at what you expect to be the peak. If you get your pullback, close them at your entry point for going long and buy calls for the ride back up :D
     

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