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Options Explained, in Kid Language

A Call Option is:

Ted is visiting Jimmy and notices a nice baseball card.

Ted: “That’s a nice baseball card! What is it worth?”

Jimmy: “About $10 right now!”

Ted: “Dude, I bet it’s gonna be worth $20 by the end of the year!”

Jimmy: “Really? I don’t think so. Wanna buy it from me?”

Ted: “Yes, but I don’t have $10 right now. All I got is this one dollar bill.”

Jimmy: “Tell you what: I’ll take that $1, and from now on until the end of the year, I’ll sell you that card for $10. Just hit me up whenever you get the money.”

Jimmy just wrote a call option for $1 at a $10 strike price to Ted.

Months go by. Ted just can’t get that $10 together to buy the card. He notices the card’s value is now up to $15. He tells his brother: “Hey, so Jimmy is gonna sell me that baseball card for $10, but it’s now worth $15, and still going up. Thing is, I don’t have the money to buy it. Can you give me $5.50 (since the call is now $5 “in the money” and guaranteed to be worth at least that much, but the card’s value can still go higher), and I’ll sell you that option?” So his brother gives him $5.50. Ted bought a call at $1, and sold it at $5.50, for a cool 450% return, without ever touching the card itself and risking very little money.

By December, the card is now worth $18. On New Year’s Eve, Ted’s brother stops by Jimmy’s house, hands him $10, then drives to the card shop and sells the card for $18. He executes the option, for a gain of $18 – $10 – $5.50 = $2.50, still a 45% return on his $5.50 investment.

Jimmy is kicking himself in the butt, because he didn’t believe that his card had that much potential. But at least he got a dollar “profit” out of the deal, without even doing anything. If the price of the card had stayed at $10 or below, he would have kept the card, and the $1 Ted gave him.

A Put Option is:

Ted is visiting Jimmy and notices a nice baseball card.

Ted: “Woah, I need this for my collection! Are you selling it? I’ll give you $10 for it!”

Jimmy: “Yeah, I’m not really attached to it and would totally sell it, but it’s worth $20 right now. And I don’t wanna get shortchanged, you know.”

Ted: “$20? That’s nuts! It’s worth $10, max!”

Jimmy: “You might get lucky soon. I heard rumors that they’re reprinting it, and then it’ll drop to basically zero. I’m actually a little worried about this, but not worried enough to sell it for $10.”

Ted: “No way that they’re gonna reprint this! Even if they do, it’s not gonna drop much below $10. Let’s do this then: Until the end of the year, you can call me anytime, and I’ll buy the card from you for $10, no matter what it’s worth. But in return, you give me $1 now up front, to compensate for the risk I’m taking on and because I need to keep the $10 handy. But if I don’t get a call from you when the year is over, I’m gonna keep that dollar.”

Ted just wrote a put option, strike price $10, and sold it to Jimmy for $1. Jimmy is happy, because even if the card is being reprinted, he still gets $10 for his card, guaranteed. He basically bought insurance against the price drop. Ted is happy, because he got a “free” dollar, and he may get the card for $10, the price he was initially willing to pay anyway.

 

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