Options Trading Basics

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by Brian Overby, Senior Options Analyst, TradeKing Group, Inc.

In an ongoing series for NerdWallet, Brian Overby, The Options Guy, will address common questions about options trading. If you have a question about options trading, please leave a comment below and he may use it in a future column.

What exactly is an option?

Options may potentially help you profit in up, down, sideways AND volatile markets, so they can be more versatile than you may be used to from stock trading. By the same token, options pose special and often higher risks that you should understand before diving in. Options are not suitable for every investor, but education about them can be.

Although options may seem unfamiliar, in fact there are several everyday concepts you likely already understand that behave very similarly to the options used in investing. Let’s talk about one of these today.

Options in movie contracts

Say you wrote a hot-property film script, and an agent wanted to “option” it. That means the agent is buying the right, but not the obligation, to consider buying your movie script for real. That right lasts for a defined period of time before expiring, and you set the price of the script in advance. For this right the agent pays you an options premium.

What does this remind you of? That’s right, these terms are similar to a call option. A call option gives you the right (not an obligation) to buy an underlying property (the script) for the “strike” price (the pre-set price for your film). That right only lasts until expiration.

During the life of the movie option, several things can happen:

•    The agent may find more backers for the project and then exercise his option, buying your script outright for the price you agreed upon.

•    Or the agent may just be speculating. They may have absolutely zero interest themselves in making your movie, but they option your script because they think other agents will come along, salivating at your project. In that case, they’d buy the option and then (hopefully) sell it at a higher price later, without ever exercising their right.

•    Door #3 is that the agent just lets the option expire. After all, optioning the movie was a lot cheaper than buying the film property outright, and it did buy him some time to try to fund the project.

This contract is very similar to the workings of a call option contract. A call option gives the owner the right to buy a stock at a fixed price for a specific period of time, and obligates the seller to take the opposite side if and when the right embedded in the option contract is exercised by the owner.

If you think about it: Option contracts pop up all over in the real world.

 

Options involve risk and are not suitable for all investors. Click here to review the Characteristics and Risks of Standardized Options brochure before you begin trading options. Options investors may lose the entire amount of their investment in a relatively short period of time.

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