I want to discuss call options and put options. A lot of people do not understand or feel confident about what options are. The reason options are important is because every day we hear about the stock market, what the S&P 500 did, and what the Dow Jones did. In addition to that, there will be three to four times more activity happening in the options market.
What is the Options Market?
An example of this is if two people are playing poker, and currently, there is a $100 bet made. An outside person bets $400 on which of the two people has a better hand. Yet, they are not even playing the game. That is the options market. There is so much more going on around the market than what is going on in the market.
Example of a Call Option
The way a call option works is something to take note of. I have used this explanation for many years, and it helps people understand. An example is, Nancy owns a lakefront property on Lake Michigan that has been in her family for the last 20 or 30 years. I mention I want to buy that property. However, I’m not ready to buy it right now, even though I still want to buy the property. The real estate people say it’s worth $350,000, although she and I both know it’s worth more than that. It is a fantastic and beautiful piece of property. You can’t reproduce it. Nancy asks me for a price when I say I want to buy it. Since this property is valued at $350,000, I’ll buy it for $400,000 if you will give me three years to decide if I’m going to buy it.
Someone Else Wants to Buy It
Nancy wants to know what I am going to give her to make that commitment to her. She also wants to know what will happen if someone else wants to buy it or if the appraisal goes up more. I tell her I’ll give her $15,000 to give myself the opportunity to buy it for $400,000 over the next three years.
For example, over the next three years, the value of the lake house goes up to $450,000. The total amount Nancy gets for the Lake House if it becomes mine is $415,000. She gets the $15,000 that I paid her for the option and the $400,000 for the sale price with a total of $415,000. She has seen the value of the property fluctuate up and down many times over the last couple of years since they have owned the property. Therefore, if the value goes down to $250,000, she has the $15,000, and she still owns the property.
Call Options for Additional Revenue
What do I get if the appraisal goes down? Nothing and I lose the $15,000 I paid for the option. The reason call options and put options exist is because, if agreed, this property can be tied up for my future purchase. The purchase can be pledged for significantly less than what she has tied up in the property itself. Therefore, what people will do in this massive market, which is three to four times the market, is to buy and sell call and put options. This is in a range to be able to have an effect in the market without having all of the money in the market. It is large institutions that are doing this. However, if you have a portfolio of stocks, you could be doing this. Many people do use these very commonly used tools. You could be selling call options and have additional revenue coming in on a stock that you already own.
