Reddit mentions of Understanding Options

The best way to explain options (not the kind you get from an employer) is to use an example. This is a summary of a great example used in Understanding Options by Michael Sincere.

Let's say that you own a hardware store in Chicago. You know that you'll probably need snow shovels in December. Last year there was a huge December snowstorm and within weeks, you ran out of snow shovels, costing you profits and annoying your customers. This year in August, you arrange an option agreement with the snow shovel maker, Shovels Inc.

The options agreement specifies that Shovels Inc. will provide you with 100 snow shovels for $15 each, although it normally charges much more. The options agreement also specifies that you have the right to buy the snow shovels for $15 each until the third Friday in December. You don't have to buy the snow shovels, but you can if you want to.

In return for this options agreement, you pay Shovels Inc. a $300 "premium" for holding the 100 snow shovels at $15 each. If it doesn't snow by the third Friday in December, you probably won't buy the snow shovels because there will be no demand for them. If there is another snowstorm, you probably will buy the snow shovels at $15 each. No matter what happens though, whether you take delivery of the snow shovels or not, you will lose the $300.

Why would Shovels Inc. sell you an option on snow shovels? First, the company receives the $300 premium from you. Second, the company knows that there is a chance you might not buy the snow shovels, so an option to buy is better than nothing.

So let's see what happens in the real world. If there is a brutal snowstorm in November and everyone needs snow shovels, the price of shovels will go up. You are delighted because you have the right to buy snow shovels for $15 each. You accept delivery of the shovels and sell them to your customers at a much higher price. That will be very profitable for you.

Let's say the Chicago winter turns out to be very mild. In this case, you don't want the snow shovels at all. You don't accept delivery of the snow shovels and the options contract expires. In this worst case scenario, you lost $300, but at least you aren't stuck with the delivery of 100 unneeded snow shovels. In a way, the options contract is an insurance policy. Shovels Inc. keeps your $300 and the snow shovels. In fact, the company will wait until January and sell an option on the 100 snow shovels to someone else. The money they make on each options contract will help them get through the mild winter.

You will lose money with options before you are experienced enough to find a strategy that fits your needs and meets your goals. There is a learning curve. The simpler your strategy the better. Options also tend to move fast in a volatile market... sometimes it is better to book a small profit instead of having it expire worthless. Good luck!

This book is alright: [Understanding Options] (http://www.amazon.com/Understanding-Options-Michael-Sincere/dp/0071476369)