Option Contract
Let’s say you and your spouse was considering buying some land and building your dream house on it someday. And one day as you were on your Sunday drive with the family, you spot the perfect looking piece of land to build your house on. You stop and you see, IT’S FOR SALE!!! So, you call the Seller of the land and the seller asks if you are ready to buy it today? You are not ready. You need 6 months to decide if you can afford to do it, to really see if you will be permitted to build your house on the land, you need to check out the schools for your kids, etc. So you tell the seller, I would like to buy an “OPTION” on the land. And you pay the seller $1,000 for the 6 month option to buy the land. During that 6 months, the option allows you to buy that land at the price you agreed upon at anytime and the seller cannot sell this piece of land to anyone else. However, regardless if you decide to buy the land or NOT buy the land, the Seller gets to keep the $1,000 forever in exchange for taking his land off the market for 6 months.
So what you, the buyer of the option, has done is buy “right to purchase” it at a specific “STRIKE” price with an expiration date on it. So, if you were sent a TEXT TRADE on this, it would look like: “Buy the 100k Call”.
Now, lets say the agreed price is $100,000. and you can purchase it at anytime during the 6 month option time frame. And remember the seller cannot sell it to anyone but you in that time frame. Well, in month 2 of your option contract, you decided not to build your dream home on it but, the land value increased by 20% for whatever reason. Because you bought the option, you could buy the land at $100,000 and sell it for a $20,000 profit. This is how Options Work in the Market. So in month 2, you decided to EXERCISE your right to buy the land at $100,000 and you turned around and sold it immediately for $120,000! (In the Market, you really didn’t even have to buy the underlying asset, because the value of the option would have INCREASED and you could have sold your option for your 20% gain). Now think of the LEVERAGE you have with options. You paid only $1,000, but you made $20,000. That is 20 times your money!! You would have never made 20 times your money if you had bought the land at $100,000. You can see here how options can give you tremendous returns.
When you buy an option contract, you pay only a portion of the Assets value in exchange to be able to purchase it at a specific price for a specific amount of time that has an expiration date.
What is Awesome is that there are 2 types of Options – Calls or Puts. When you buy a Call Option, you want the underlying asset (in the case the stock price) to go UP! The higher it goes up, the more you make exponentially because of the leverage of options.
When you buy a Put Option, you want the underlying asset to go DOWN! The more the asset (the stock) goes down, the more you make exponentially!
INTRODUCING STRANGLES AND STRADDLES –
When you buy both a Call Option (you want the stock to go UP) and you buy a Put Option (you want the stock to go DOWN) AT THE SAME TIME, that is called either a Strangle or Straddle. So, what do you want to happen? You want it to go WAY UP or you want it to go WAY DOWN. You don’t care which way. What you don’t want is for the Stock Price to stay the same. The value of the option will go down if the Stock stays the exact same price the whole time.
So what is the goal when you buy a Strangle or Straddle, YOU WANT THE STOCK PRICE to move in one direction dramatically!
You can sell Options, but with TextMyTrade.com, we are only going to be involved with buying options.
Before we get into the differences of Strangles and a Straddles, lets talk about Strike Price.
The Strike price is defined as the price at which the holder of an option can buy (in the case of a Call Option) the underlying security when the option is exercised. Hence, strike price is also known as exercise price.
Now think of the $100,000 Land where you bought the Call Option on it for $1,000. Let’s assume that the $100,000 was the Exact True Value of the land at the Exact time of you buying the Call Option. In the Market, we call that ATM or “At the Money”. If the Land value never changed, the value of the option actually decays or goes down. If the Land Value goes UP, so does the Option Value. And if the Land decreased in Value, your $1,000 Option would expire worthless because nobody would want to pay $100,000 for the land if the value of it went down to $80,000.
Relationship between Strike Price & Call Option Price
For call options, the higher the strike price, the cheaper the option. The following table lists option premiums typical for near term call options at various strike prices when the underlying stock is trading at $50. You see, Just like the Land, if the value of the asset goes up, so does the Call Option Price. Remember the Call Option that you bought with the land was $1,000 and the Land went up 20%, well your Call option price would have increased in VALUE too!
| Strike Price | Moneyness | Call Option |
||
| 35 | ITM | $15.50 | ||
| 40 | ITM | $11.25 | ||
| 45 | ITM | $7 | ||
| 50 | ATM | $4.50 | ||
| 55 | OTM | $2.50 | ||
| 60 | OTM | $1.50 | ||
| 65 | OTM | $0.75 |
Relationship between Strike Price & Put Option Price
Conversely, for put options, the higher the strike price, the more expensive the option. The following table lists option premiums typical for near term put options at various strike prices when the underlying stock is trading at $50
| Strike Price | Moneyness | Put Option | ||
| 35 | OTM | $0.75 | ||
| 40 | OTM | $1.50 | ||
| 45 | OTM | $2.50 | ||
| 50 | ATM | $4.50 | ||
| 55 | ITM | $7 | ||
| 60 | ITM | $11.25 | ||
| 65 | ITM | $15.50 |
Using the Above OPTION CHARTS which is called “option chains”, we can now explain the differences of Strangles and Straddles:
With a Strangle, you are buying 2 different Strike Prices – for example, you could buy the Call Option with strike price at $55 for $2.50 AND at the same time, you buy the Put Option with strike price at $40 for $1.50. So, if you bought one share of each, you would totally spend $4.00 – This amount is called the NET DEBIT.
Lets look at what can happen here: You have invested $4.00, so to earn 10%, you will need to SELL at a NET CREDIT for a Total of $4.10. In the Market, we suggest that you put an AUTOMATIC “NET CREDIT” LIMIT sell order in for $4.10, so that as soon as it hits it, the trade happens automatically. Looking just at the Call Option for a moment, Look at the difference of the Strike Price for the $55 verses the $50. So, we can assume that if the Stock goes up $5, the VALUE of the Call Option will go up to about $2. And you, my friend, would sell the Call Option because your value would be around $4.50 OR it would have already sold at $4.10 if you had placed the Net Credit Limit order to sell in.
