What are Options? - YouTube

In order to understand what options are, let’s start with an example.

Meet Zoey.

Zoey has a car.

This is Bill.

Bill requests from Zoey to give him the right to buy the car from her at 15K in cash anytime

during the next month.

Zoe might agree on the condition that Bill pays her 2% of the value of the car, which

is 300 dollars, for waiting out the month without a transaction.

Zoe cannot sell her car to anyone else during this waiting period.

Bill does not have to buy the car in this time frame, but he does have the right to

do so.

Let’s look at the definition: An Option is a contract allowing the recipient

the right, but not the obligation to transact a known transaction (buy or sell) of a known

Asset at a known price in a known pre-defined time frame.

A contract - The Option agreement between two parties.

A recipient (of the Option right) - in our case it’s Bill - also called “option buyer”

or “the option holder.”

A known Asset - The core of the option - in our case, it’s Bill’s opportunity to buy

a car from Zoe.

The person giving the right and taking upon himself the obligation (in our case Zoe) is

sometimes called the “originator” or “option writer” or “option seller.”

At a known price - $15,000, also called “strike,” and $300, which is the price of the option.

In a known pre-defined time frame - in our case - One month, after that time, the option

has no value.

This pre-defined time frame in which the option will be exercisable is called the option’s

Term or Duration.

Options that can be exercisable at any time during the time period are called American

Options.

Options that can be exercised only at the end of the period are

called European.

The technical name of an Option that involves the right to BUY an asset at a price is a

CALL Option.

In our case, Zoe sold a Call Option to Bill.

Options are very useful tools in business and are indeed used to help execute all sorts

of transactions and help reach all sorts of business goals.

Here are few examples:

a.

Sara is a real estate entrepreneur.

She meets Phillip, the owner of some land close to the beach, who wants to sell his

property.

Sara knows of some friends who would love to buy luxury apartments in this location,

which is a high demand zone and characterized by limited supply.

Sara approaches Phillip and proposes a deal: The owner will award Sara with the right,

but not the obligation, to buy the land for three million dollars any time within a 24-month

period.

Within this time, Phillip’s Property is off the market, and Sara will have time to

proceed.

Sara has high conviction in the project and pays Phillip $50,000 for the option on the

land.

Sara then prepares the plans and finds out she can build 30 condominiums.

She approaches ten friends and offers them to buy a condominium from her at $750,000.

Eight agree to the transaction and are willing to commit half the proceeds up front to secure

the property.

Sara has sufficient capital to secure the deal and now Exercises the option to buy the

land.

In this case, Phillip sold a Call Option to Sara.

b.

Margaret owns a coffee shop chain.

One day, a competitor approaches her with a proposal to purchase 50% of her business.

Margaret is happy to accept the cash offer and negotiates a two million dollar company

valuation.

For some reason, the buyer doesn't want to buy the whole company, and Margaret worries

that differences in business approaches and management styles might pose a problem.

Jeff, Margaret’s friend, comes up with an Idea:

The Buyer will purchase half the business for 1,000,000 dollars but will also Grant

Margaret the right but not the obligation to SELL her full remaining stake in the business

for 1,000,000 dollars (based on the existing valuation times 50% remaining stake) for a

term of five years.

Margaret had the option to SELL her share at a price they agreed to before; this option’s

technical name is a PUT option.

Think of the Option recipient (Margaret in our case) putting the now worthless remaining

shares in her partner’s hands and taking the money from his pocket.

If Margaret executes the Option, the buyer must comply.

The buyer awards Margaret the Option and the deal is executed.

The competitor buys 50% from Moonbucks Coffee Shop.

Margaret is 1,000,000 dollars richer.

The new partner demands to improve profitability and takes drastic measures such as firing

two critical high-cost employees.

Profits promptly plummet resulting in an operational loss.

Margaret is devastated, but Jeff reminds her of her Option to sell the remaining stake

in the company so Margaret promptly exercises the Option to sell.

The Partner competitor finds to his dismay that now he can’t back out from the deal,

and must shell out an additional 1,000,000 dollars to buy a now worthless, loss-generating

business.

Now Margaret can take her dream vacation and sip margaritas with Jeff.