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What Is An Options Contract? - Options Mechanics - Options Trading For Beginners - YouTube
Channel: Option Alpha
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Hey everyone.
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This is Kirk, here again at optionalpha.com.
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In this video, the first video here in track
one, we’re going to be going through what
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is an options contract.
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Really, for me, this lays the foundation for
everything that we do here.
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If you don't understand what an options contract
is, who the parties are that are involved
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and the basics behind it, it’s going to
be really hard to get to the next level.
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This is why this is the first video in our
beginner series here at Option Alpha.
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Without going into too much industry jargon
and terminology, I want you to understand
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first and foremost that an options contract
is simply an agreement between two parties
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for the sale or purchase of some underlying
asset.
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In the case of what we do here at Option Alpha
and what most people use options contracts
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for, it's the sale or purchase of stock or
stock in a particular company or some asset.
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But you can actually use an options contract
in many different areas and markets.
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You can use them in real estate, in business
deals, to buy cars.
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You can use them all over the place.
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It’s not limited to just the stock market.
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But in our case, that’s what we’re going
to be focusing on here today.
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The way that I teach it (and this is how I
do it a lot with coaching students) is I just
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use this simple visual example that I draw
all over the board.
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You’ll see me doing this here.
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We’ll go through a lot of different scenarios
and different terminology and a lot of this
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might start to stick now, but it will as we
go through each individual terminology and
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step later on in track one.
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I want to lay the foundation here, I want
to give you the overarching theme of what
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an options contract is and then we’ll dig
deeper and deeper and deeper as we get through
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this training.
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Here’s the deal.
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An options contract like I said is just an
agreement between two people.
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In this case, we have our stock certificate
which is going to act as the middle.
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This is what people are agreeing on.
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This is what they’re building up this contract
for.
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We’ve got a buyer and a seller, so we have
somebody who wants to buy the stock certificate
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or the stock and we’ve got somebody who
wants to sell the stock.
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In this case, we’re going to say that currently,
the stock right now is valued at let’s say
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$10, so this stock (whatever it is) is currently
valued at $10.
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In a typical stock transaction, (just to show
you the difference real quick) if the seller
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owns the stock and the stock is valued at
$10, then the stock buyer can come in and
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buy that stock for $10 and that $10 gets transferred
over to the seller and the stock now goes
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to the buyer.
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Simple transaction, the buyer buys it for
$10, the seller sells it for $10.
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In an options type of environment, we have
a lot of different scenarios that can happen
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around that $10 security right now.
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In our case, we use a very simple example
just to prove a point.
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But let's say that that option buyer is communicating
with that option seller and says that they
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actually want to buy the stock if the stock
goes up in value and they want to buy the
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stock in the future at some predetermined
price.
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Let's say they want to buy the stock for $50
a share in the future.
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This is starting the basis of what this option
contract is built around, is the assumption
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on one party’s end or another of future
value of the underlying stock.
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This buyer could go out there and they could
buy the stock right now for $10, but what
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they want to do instead is they want to make
an agreement, an options contract between
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themselves and the seller that says “At
some point in the future, I’d actually look
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to buy the stock for $50.”
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First, most people would ask and they’d
say, “Why would somebody want to buy the
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stock for $50?”
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Well, what if in the future, that stock is
actually worth not $50 or not $10, but is
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actually worth $100 at some point in the future?
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What if they get a big government contract
or they discovered the cure to cancer, whatever
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the case is?
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Now, the stock goes up from $10 to $100.
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Now, that option buyer had a contract in with
the seller to buy the stock at $50 and now
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it’s worth $100.
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That’s the reasoning behind why somebody
would want to do this in the future on the
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option buyer side.
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Now, just to take a step back for a second,
if let’s say the option buyer said that
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they wanted to buy that stock for $50 in the
future, they also have to set a timeline and
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have to pay consideration to the option seller.
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Those are two key points that we want to go
over now, is that they have to set a timeline,
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so when is the future date expired, when is
expiration of this agreement between two parties.
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Let’s say that this agreement only last
for one year.
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From one year from today's date, the option
buyer can purchase this stock at any point
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in the next year for $50 or not.
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They have the option.
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That's where the option part of it comes in.
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Again, one year from today's date, the option
buyer can choose to purchase stock in this
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company for $50 a share or not.
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They don't have to, but they can choose to
do that.
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That gives us our timeline of how long this
contract last.
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After a year is up, let’s say it’s one
year and one day from today, then the option
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buyer no longer has the right to buy that
stock at $50.
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Their contract with the seller has expired.
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That’s where our expiration process comes
into play.
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In most options markets, expiration processes
can be a week long to a month, two months,
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three months, a year, two years, three years,
so there’s varying degrees of timeline.
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In order for the seller to agree to doing
this…
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Because again, put yourselves in the shoes
of the seller.
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Now they’re going to say, “Okay, I'm basically
guaranteeing that the most I can sell this
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stock for in the future is $50 and then if
it goes anything higher than $50, I’m going
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to have to sell it to this option buyer for
$50.
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I need some sort of consideration right now
to basically give up my right to sell the
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stock over $50.”
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Because again, the option buyer can buy it
at $50 and sell it for whenever the current
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market value is in the future and in the example
that we used, it was $100.
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Now, the option buyer has to pay the option
seller some sort of consideration and let's
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say that in order to execute this agreement,
the option buyer pays the option seller let’s
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say $40.
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The option buyer is going to pay the option
seller $40 right now.
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That's the premium that they paid and that
basically tells the option seller, “Look,
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I'm a legitimate buyer, I want to compensate
you right now for this contract or this agreement
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that we’re making and if I don't make good
on my contract, meaning if I never buy the
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stock any time between now and a year later,
if I never buy the stock, you get to keep
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this entire $40 premium for yourself.”
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This is now where things start to get a little
bit more confusing, but if you start thinking
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about it logically, this is why each side
of the agreement between the options buyer
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and seller has a little bit of skin in the
game.
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The options buyer wants to pay a little bit
of money, so they’ll only going to pay $40
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right now, but they basically control this
stock and hope that it goes above $50 a share
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or on the other side, the option seller hopes
that the stock goes up, but not more than
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$50 a share because if it doesn't go more
than $50 a share, they get to keep this $40
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premium for themselves for basically releasing
the right to anything above that price.
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Hopefully this example makes a lot of sense.
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It's just an agreement between two people.
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There’s a million different ways that this
can happen.
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The agreement can be at a $50 strike price
or where they agreed that they’ll buy and
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sell stock back and forth to each other or
the agreement could be at $40.
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There’s a lot of different variations between
where the agreements can happen between the
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two parties.
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If the current stock price is $10, they might
agree to a $40 strike price, meaning that
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if the stock goes up to $40 or more, then
the option buyer will execute their agreement
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and assign or request the stock from the option
seller and they will hope to sell it for more
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than $40 a share in the market.
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There’s a lot of different variations.
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There can be different time variations.
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Instead of one year, they might agree to just
six months.
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Instead of doing a one-year contract, they
might say, “Hey look, this contract is only
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valid for six months instead of a year.”
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The option consideration or the premium that
the option buyer pays to the seller, instead
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of being $40 because it's a lower time amount
might only be $30 or some other different
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factor.
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There’s a lot of different ways that it
can go, but hopefully this makes a lot of
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sense about just the basics.
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It's just an agreement to buy or sell stock
at some point in the future and we’ll get
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into a lot more of the rights and responsibilities
here later on in the track.
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The first couple of things that I want to
break down and just go over a little bit more
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in detail are these key concepts.
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We’ll talk about more of these with a lot
of examples here in track one, but the first
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one is strike price.
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Strike price is the point at which they make
an agreement on the future value of the stock,
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future value of the stock.
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In this case, when we're looking at this example,
the stock was worth right now $10.
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The strike price that they determined for
the future value was $50.
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That is the strike price.
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The way that I always explain it is that’s
the price at which they strike a deal on the
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future value of where that stock is and that
could be higher or lower than where the stock
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is now.
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Premium compensation: This is the amount of
money transferred from the buyer to the seller
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for entering that agreement.
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In the options world, the buyer always pays
the premium and the seller always receives
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the premium because the buyer is accessing
a right and the seller is giving up an obligation
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or giving up their right and basically taking
on obligations.
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They have to be compensated for doing that.
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In our example above, the initial premium
that was paid from the buyer to the seller
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for this contract was $40.
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That was how much the buyer was going to pay
the seller to enter into this agreement.
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Time consideration: This is a big one.
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All options contracts have an expiration date.
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There has to be a time at which they say that
this agreement between two parties no longer
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last.
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In the options world, that varies anywhere
between a week, maybe a month, two months
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and can be up to many, many years.
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There has to be some time component into that
contract.
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As you’ll learn later on, the longer that
time component is, the more valuable that
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contract is because there’s more time for
the security to move into a favorable zone.
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Exercise and assignment: This is a big one
because most people really don't understand
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how that works.
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But let’s go back to our example here to
describe how it works.
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If let’s say the stock in the future or
the strike price that we’re going after
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or the option buyer’s going after is $50
a share and let’s say that in the future,
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the stock is actually worth $100 a share,
not $10, so the value of the stock has gone
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up from $10 to $100.
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In this case, the buyer would request, so
they would submit a request to the seller
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for the stock.
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That is called an exercise.
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They’re basically exercising their agreement
that they had initially signed, their options
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contract that they had initially signed and
now they are physically requesting the seller
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to sell them stock at $50, so that they can
go out and resell the stock…
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Because they’re going to buy it at $50,
they’re going to resell the stock for $100
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and take in the difference as a profit.
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That is called the exercise request.
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On the seller’s end, what it looks like
is it actually looks like the option is being
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assigned, meaning that that contract that
they initially sent over is now being assigned
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to the option buyer, meaning that they have
to give up their stock that they have and
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now transfer that stock over to the option
buyer for the strike price of $50.
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That’s the difference between exercise and
assignment.
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It’s actually the same transfer happening.
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It’s just if you're an option buyer, you
exercise your right to buy the stock.
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If you're an option seller, you get assigned
a contract and have to give up that underlying
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stock.
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Hopefully that makes sense of the differences
between them.
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Rights and obligations: Rights and obligations
are a little bit confusing initially on the
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outside because you don't really know what’s
happening.
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But if you break it down and really think
through the process, remember that if you
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enter into an agreement with the option buyer
and you're an option seller, you’ve basically
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given up your right to the stock for anything
above $50.
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If the stock is worth less than $50, the option
buyer is not going to exercise their agreement.
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They’re not going to buy a stock at $50
a share when it's only worth $40 a share in
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the open market.
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They’d rather go out and buy options in
the open market for $40 a share versus buying
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it from you at $50.
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But as the option seller, you don't have that
decision anymore.
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The option buyer has paid you money to basically
make the decision on whether they will buy
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or not buy the actual stock based on the options
contract.
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The right to buy or not comes with the option
buyer.
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They pay for a right.
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They pay for the choice to buy or sell that
stock or not buy or sell that stock in the
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future.
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As the seller, you have given up your right
and now you have an obligation because you
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took in money, you accepted this contract,
you took in that premium from the option buyer,
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now you have given up your right and now you
have an obligation that if they do want to
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buy (because you agreed on it) that you will
sell them stock at a predetermined price in
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the future.
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That’s the difference between rights and
obligations and we’ll dive a little bit
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more deeper into this later on in the track,
but I think hopefully that lays the foundation
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for what we’re doing here with options contracts.
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Now, to quickly wrap up everything that we
just talked about, it’s important to understand
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that all an options contract is, is just an
agreement between two parties for the sale
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or purchase of an asset and hopefully this
quick visual that we went through today lays
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the foundation for how you can start to understand
and develop a trading strategy around options
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trading versus just going out and buying the
stock from the open market.
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It gives you a lot of choices, no pun intended,
it gives you a lot of options on things you
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can do, and that creates opportunity for us
as traders.
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