What IS an option - and why might you consider adding options to your investment portfolio? In a new back-to-basics series, TradeKing’s Brian Overby explains options from the ground up, from opportunities to risks. This post offers three “real-world” comparisons to explain how stock options work.
 
It’s a new school year, and we’ve been opening our doors to thousands of new investors over the last few months. I thought this back-to-basics series would be a great way to introduce options to those who are curious about them.

As I noted before, options can 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. This series aims to get you started right.

My last post defined options, both calls and puts, and talked about some high-level issues that define the options-investing game. But there’s no need to get too abstract too quickly. Although investment options may seem unfamiliar, in fact there are several everyday concepts you already understand that behave very similarly to the options you use in investing. Let’s run through a few of these today.

(By the way, it goes without saying but I’ll say it: options for investing aren’t EXACTLY the same as any of the examples below. Other factors and terms come into play. But they’re alike enough to investment options to help you get a better grip on these concepts. Options are complex, involve risks, and are not suitable to all investors. Be sure to read Characteristics and Risks of Standardized Options before you begin trading them.)

1.    Options are like…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. Again, a call 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.

2.    Options are like…sports contracts

This ESPN article on Brett Favre’s new deal with the Minnesota Vikings is another great example of options-parallels in the real world. Here’s the operative quote from the ESPN story:

“The Vikings will pay Favre $12 million this year and $13 million next season, sources told ESPN senior NFL analyst Chris Mortensen and ESPN NFL Insider Adam Schefter. The contract does not contain performance bonuses.

Because Favre is a vested veteran, the $12 million is guaranteed for this season if he is on the opening day roster. This also applies to the $13 million 2010 deal. This year, $6 million is guaranteed for skill and injury, meaning that if he is bad during the next few weeks, the Vikings can't get out for less than $6 million.
The 2009 salary payments are deferred: $4 million over the season, $4 million in March and $4 million in 2011.”

In other words, you might say Favre sold a call for $6 million with the potential to make $12 million. Favre himself is the underlying property of the contract, so it’s a “covered call”, which we’ll discuss more in a future post.

Make sense? Options have lots of real-world parallels than may help you understand the basic mechanics a little better. In my next post, we’ll move on to options quotes. As you’ll see, the terms of a standardized option contract are spelled right out in the option’s name. Stay tuned for more!

Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com

[image: School bus by kevindooley on Flickr]

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options available at http://www.tradeking.com/ODD.

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