Trading stock options is essentially the buying and selling of options contracts.
Logically that makes no sense nor helps you see how you can make so much money doing so, but stick with me for a second and let me walk you through an example.
An options contract is an agreement made between two parties in regards to buying or selling a stock.
"Real estate investors" buy and sell homes
"Stock Traders" buy and sell shares of stock
"Option traders" buy and sell contracts
Now I'm going to explain option trading in a way that has nothing to do with the stock market.
This will help you understand how trading stock options (buying and selling contracts) can be so profitable.
Let's say you find an undeveloped piece of land that you believe will increase in value over the next few years. The land is in the middle of nowhere, surrounded by 20 miles of forest on each side.
It's valued at $25,000. You don't want to buy the land outright, but you would like to tie up the land with a contract that gives you the right to buy it at a later date in the future.
So you give the owner some money and he draws up a contract that gives you the "right to buy" the land any time during the next 3 years for a "set price" of $25,000.
You pay him $2,000 for the rights of this contract. You're not "obligated" to buy the land, you've just purchased the "right to buy it".
If you decide not to purchase the land your contract will expire, and you'll lose your $2,000 investment.
Two years later the city has built a new mall 15 few miles down the road. New housing developments have gone up and Wal-mart builds a store right next to the lot that you have the contract for.
Remember you have the "right, but not the obligation" to purchase that lot next door for $25,000 AND you only paid $2,000 for the contract.
Two years ago the land was only worth $25,000 because nothing was around it.
Do you think the land is worth more now that there are malls, new homes, and Wal-mart next door?
Yeah, you bet your bottom that lot is worth more than $25,000. For exaggeration purposes, let's say the lot is now worth $100,000.
You're extremely happy! You own a contract that says you get to buy a $100,000 piece of land for only $25,000.
**On a surface level understanding, can you see how this contract is now more valuable because the underlying asset (the land) increased in value?**
If you exercised your rights of the contract and bought the land you could keep it, or sell it on the open market and pocket the difference between what you sold it for and what you paid for it ($73,000 or a 270% return on your investment).
Please Note: a fact that needs to be taken into account is that if you were to buy the land (exercise the terms of the contract), you would need $25,000 and only then could you sell it for $100,000, thus realizing the profit.
Now here is why trading stock options is so profitable:
An options trader would simply take that contract and sell it to someone else.
You own a contract that says you have the right to buy a $100,000 piece of land for only $25,000. Do you think someone might be willing to pay you more than $2,000 to own that contract?
Yes, any person in their right mind would.
So an options trader would simply turn around and sell the contract to someone else for a higher price.
You decide that you don't want to own land and you'd rather sell your contract to someone else.
**You sell your contract to a local land developer for $20,000 and you walk away happy because you just made an easy $18,000 dollars or a 900% return on your investment.**
And yes those types of returns are real. Every now and then I share those with newsletter subscribers.
So now you have an example of how buying and selling contracts can be profitable. It's also probably one of the easiest ways to explain options trading because as an options trader, buying and selling contracts is what you'll be doing.
**Tip** Do not dig deeper into the example. A lot of people try to figure out why a person would let someone tie up their land.
Others want to know why the person who bought the contract didn't just buy the land. Just keep your thinking on a surface level for now (trading stock options is simply buying a contract and selling it at a higher price).
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Products Created by Trader Travis
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Free Options Course Learning Modules
Module 1: Option Basics
Module 2: Option Value
Module 3: Basic Strategies
Module 4: Stock Charts
Module 5: Technical Indicators
Module 6: The 7-step process I use to trade stock options