This articles is from @SahilBloom who is one of the best mentor about finance that willing to share all of his knowledge for free. So if you like the post, please give him a follow and share his lessons.
Over the last few months, with the rise of Robinhood and the day trading boom, options trading has been featured prominently in the news (for better or for worse). But what is an option and how does it work?
In simple terms, an option is a contract. It gives the buyer the right, but not the obligation, to buy (a “call”) or sell (a “put”) an asset. It specifies the price at which the asset can be bought or sold (“strike”) as well as a date this must occur before (“expiration”).
The buyer of the option has to pay to have that right to buy or sell. The “premium” is the price they pay for the option.
Let’s use a simple example to illustrate how this works.
Imagine you are in the market for a new house. You find the perfect one in a town nearby. You hear the town may get a nice new mall, so housing prices may rise quickly. Paul, the house’s owner, wants $1M for it. You don’t have that kind of money today, but you will soon.
You don’t want Paul to put the house on the market. You worry someone else will snatch it up! So you offer Paul a deal. You’ll pay him $50K today for the right to buy the house for $1M before December 31. Paul agrees to the deal.
Congratulations, you just bought a call option!
Strike = $1M Expiration = December 31 Premium = $50K
One of two scenarios now plays out: 1️⃣ - Mall Built = 🏠 Prices ⬆️ 2️⃣ - Mall Not Built = 🏠 Prices ⬇️
In scenario 1, you “exercise” your option to buy the house for $1M. You are happy. The house is worth $1.2M now and you got it for $1M (plus the $50K option premium). In scenario 2, you don’t exercise. The house is now only worth $900K. You’re only out the $50K, so it’s ok.
So you were effectively in control of a $1M house for only $50K.
The easiest way to think of a put option is that it is an insurance policy. Imagine you own a house that is worth $1M. You live in California, so you worry about earthquakes. You decide to buy an insurance policy. So you call up your rich friend, Paul. You offer him a deal.
You will pay him for an insurance policy on the house with $1M of coverage. You’ll pay $50K for the policy, which will expire in December 2025. Paul accepts. Congratulations, you’ve just purchased a put option! Strike = $1M Expiration = December 2025 Premium = $50K
You’re not as worried about an earthquake now. You’re covered!
One of two scenarios now plays out: 1️⃣ - No Earthquake = 🏠 Fine 2️⃣ - Earthquake = 🏠 Damaged
In scenario 1, you don’t “exercise” your option. The house is fine. You’re only out the $50K premium - worth it for the peace of mind! In scenario 2, you exercise your option. The house is damaged. Paul pays you $500K for the damages. You’re happy you bought the insurance.
So to summarize
Call Option = Bullish Bet Put Option = Bearish Bet
Why buy options? ▪️Speculate on price movements ▪️Hedge long or short exposure
If you follow the stock market and financial news, you’ve undoubtedly heard a lot of talk about margin trading or margin calls. But what is margin trading and how does it work?
First, some definitions. “Buying on margin” is just the financial jargon for using loaned money to buy assets. Someone loans you money and you use it to buy a stock - you are buying on margin. “Margin” is defined as the total value of the asset minus the borrowed amount.
When you buy on margin in a brokerage account, the stocks you buy are collateral. This is the same as buying a house with a mortgage. The house is collateral for the loan. So how does it work and what is the deal with the dreaded margin call? Let’s look at a simple example.
Imagine you want to buy a plot of beachfront land on the coast of Nicaragua. It’s beautiful, but still pretty cheap due to political instability. It’s the next Costa Rica! You’re sure of it. The land costs $1M today. So you ask your rich friend Jimmy for a loan to buy it.
You put up $200K and Jimmy loans you the remaining $800K. You buy the land and are the proud owner of prime Nicaraguan real estate. Congratulations, you just bought on margin! Margin = Asset Value - Loan Value Margin = $1M - $800K Margin = $200K
Shortly after you buy the land, riots break out across the country, causing tourism to grind to a halt. Land values plummet. Jimmy starts to get nervous. He previously had $1M of collateral covering his $800K loan, but now the market value of the collateral is just $500K!
Jimmy calls you, explaining that he needs you to put up some additional cash as collateral to make him whole. Otherwise, he will be forced to seize the collateral (your Nicaraguan beachfront land!) and walk away. This was a “margin call” (literally and figuratively!).
In an alternate universe, if the land value had increased, the returns on your $200K investment would have been amplified given you bought the land on margin. Effectively, buying on margin is a way to amplify returns on the upside, but it also amplifies risks on the downside!
It is essential to educate yourself before entering into a loan agreement (whether for a house or a brokerage account). Never trade on margin if you are going to be in financial distress if you get margin called! So that’s a simple primer on the topic. I hope it was helpful!
This articles is from @SahilBloom who is one of the best mentor about finance that willing to share all of his knowledge for free. So if you like the post, please give him a follow and share his lessons.