Options are one of the mysteries of the stock market. Many people have heard of them, but few understand how they work. Through this series of lessons, we would like to provide you with a brief overview of what options are and how they work.

When you buy an option on a particular stock, you haven't purchased the actual stock itself, you have simply bought the right to buy or sell the stock under certain predefined conditions.

Depending on these conditions, the purchase of this stock could result in a significant profit for the buyer of the option. This would cause the buyer of the option to move onto the next phase and exercise their option and purchase the stock under these favorable conditions. This purchase of the stock is a separate transaction from the purchase of the option.

However, there is also a second possibility. Because of the favorable conditions attached to this option, others may be interested in purchasing the option you own.

Let's Illustrate

Let's say, you wanted to buy a particular piece of property. For a variety of reasons, you are not ready to purchase it just yet, but you have a hunch that property values are going to go up very quickly. So you ask the owner if you can have an option on the property that gives you the right, but not the obligation, to purchase the real estate for its current fair market value of $200,000, and you buy that option for 5000.00 three months down the road.

Now the sale of the option, legally obligates the owner to keep his property off the market until you make your decision. The owner is limited in what revenues he can earn off this property.

So in the end, he agrees to sell this option to you for $5,000 to make up for lost revenues on this property during the option period. This option price is non-refundable, you are simply compensating the owner for lost revenues during the option period.

If at the end of the three months, you decide to purchase the property, you will end up paying $205,000 -- $200,000 for the purchase of the property and $5,000 for the option.

If, however, you decide that the conditions are no longer favorable for you to purchase the property you can walk away from the deal and only be out the $5,000 option premium.

Now let's take a look at how this option works under different scenarios:

Scenario #1

Scenario #2

Over the next couple of months, as you anticipated, there is a big announcement of new factory being built in the community. Suddenly, there is a huge demand for real estate and this property escalates in value to $250,000. But the option which you had purchased for $5,000 obligates the owner to sell the property to you for $200,000. You do the only logical thing and you exercise the option. You get the $200,000 and you buy the property. The next day you turn around and sell the property for its current value of $250,000. You end up with a net profit of $45,000 once you subtract your initial option payment of $5,000. You are smiling all the way to the bank.

Let's say you decide you don't really want to buy the property. There could be a number of reasons for this you can't raise the cash or you don't want to go through all the hassle of buying the property. But there is inherent value in this option since it gives you the right to buy property worth $250,000 for just $200,000. So you decide to approach a rich friend who likes sure fire deals like this. You have to sell your friend this option before it expires, because the owner will certainly not be interested in going through with the sale for $200,000 if he can make more money in the current market. Of course, when you decide to sell this option, you want to make sure there is some money in it for you as well. So you approach your friend and you offer to sell him the option on the property for $15,0000, earning a $10,000 profit on the deal after you take out the $5,000 you paid for the option. Your friend is immediately interested because for $15,000, can purchase the property for $200,000, sell it for $250,000 and net a quick $35,000. Not a bad days work. So who made the most money on the deal?

So who made the most money:

Though you didn't do to bad on this deal. For three months of work, you earned $10,000 after buying the option for $5,000 and selling it for $15,000.

But clearly your friend was the big winner, after spending $215,000 ($200,000 for the property and $15,000 for the option he made $35,000, triple of what you made.

But was he the big winner?

After paying $5,000 for the option, you made a net profit of $10,000, that's a 200% return on your investment.

After spending $215,000, your friend made a profit of $35,000, a return of 16%. Certainly, nothing to sneeze at, but miniscule in terms of what you just made.

Considering the level of your investment, you are clearly the winner.

Welcome to the crazy world of options.