An introductory explanation of equity options

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I detest losing money unless I learn a good lesson from the experience.   I’ll try to save you money by sharing the lessons for which I have paid.  If nothing else, you can click the image above and get my recipe for a fabulous Ramen noodle soup while you ponder George Goodman’s advice:

If you don’t know who you are, the stock market is an expensive place to find out – George Goodman


 

Options – Rights and Obligations

If you buy an option, you acquire the right to buy or sell something at a specific price and time.

If you sell an option, you acquire the obligation to buy or sell something at a specific price and time.

Ever put down a deposit on a vacation/holiday?  Then you have purchased an option.  You’ve bought the right to pay for a vacation at a fixed time and price.  You can choose to proceed or not.  You have purchased an option and have the right, but not the obligation, to pay the balance and take the vacation.

The business that took your deposit has sold you that option.  They have some of your vacation money in advance but they are now committed to selling you the vacation you want at the price you struck when paid the deposit.  The risk for them is that you don’t pay the balance and they have to find another client (possibly at a very late stage) to fill your place, but as compensation, they keep your deposit.

You have the choice (For which you have paid) to take the vacation and pay the balance.

The travel company has the obligation (For which they have been paid) to deliver the holiday you want at the price agreed when the balance is paid.

Equity options follow these principles.  Principles that owe more to the insurance industry than to shares in a stock market.  Let me explain.

Perhaps a large portion of my retirement fund is in the shares of a company that is paying me a dividend.  I want to enjoy the dividends for the foreseeable future. My risk is that the company may reveal very poor results or worse still, accounting fraud is discovered and the share price collapses.  Rather than see my retirement income disappear, I could purchase an option that gives a counter-party the obligation to purchase my shares if they fall below a certain value (strike price).  For that, I pay a “premium”.

The counter-party who sold me the option is now committed to purchase my shares at a price I have chosen should the value drop.  For this, they receive my premium.  If the shares do not drop to the strike price, the counter-party keeps the premium.

It’s like auto-insurance but for the stock market.  The difference is, that it’s not compulsory insurance and you can decide whether you want to be a buyer or seller of that insurance.

The Naked Putz takes this ability to sell options and turns it in to an income stream.

© The Naked Putz 2015

 

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