to help you understand how options work
we're gonna look at one type put options
and compare them to something you're
more familiar with car insurance like a
put options trade car insurance is a
transaction between two parties a buyer
the car owner and a seller the insurance
company the buyer purchases the
insurance contract for a fee which by no
coincidence is called a premium this
contract locks in certain rights and
obligations to put it simply if damage
happens to the car the buyer has a right
to file a claim when this happens the
insurance company is obligated to pay
the buyer for any damage done now let's
talk about the premium the cost of an
insurance contract is a function of a
few factors the most significant is the
price of the underlying asset it's
insuring which in this case is the car
the more valuable the car the higher the
premium if you insure a Porsche you have
to pay more than you would with a Honda
Civic time is also a factor some choose
to pay car insurance every month while
others pay every six months the longer
the time the higher the premium don't
forget about risk insurance companies
look at certain characteristics of
drivers to determine how risky they are
for example teenagers are perceived as
more volatile than say more mature and
responsible drivers much to parents
dismay an insurance contract will likely
be more expensive for teenagers so the
insurance premium is derived from
several factors price time and risk
these factors are very similar for an
options contract the price of the
underlying asset is the most significant
factor options tend to be much more
expensive when the underlying stock
costs $700 rather than 10 dollars also
timing is an important element the more
time between now when the option expires
the more expense of the contract and
lastly there's implied volatility some
stocks and ETFs are riskier than others
some stocks like biotech for example
could be considered the teenagers of the
investing world while blue chips with
healthy dividends are more like mature
stable elders of the market now that
we've covered price let's return to our
car insurance analogy and look at how
the value of the foot' contract might
change of certain outcomes occur now if
nothing happens over the
the insurance contract it simply expires
it's a small loss for the buyer and the
seller keeps the premium insurance
companies stay in business because a lot
of contracts play out just like this but
on the rare occasion that a car gets
total why the insurance contract is
enforced then the value of the contract
changes exponentially it was a small
cost of the buyer becomes something that
possibly pays off tens of thousands of
dollars and the flipside is true for the
seller it was a small potential profit
becomes a big loss the same is true for
put options put options gain in value
when the underlying stock or ETF goes
down in value when the underlying drops
in value a put can go from a relatively
small expense for the buyer to something
that's worth a whole lot and for the
seller it's the opposite it goes from a
small potential profit to a potentially
large loss however there are some
important differences between car
insurance and options contracts first
with options trading you can either be a
buyer or the seller so in essence you
can play a role similar to the car
insurance company additionally when
you're an option buyer you don't even
have to own the underlying asset suppose
the rambunctious kid down the block just
turned 16 his parents bought him a
brand-new Corvette Stingray wouldn't it
be great if you could buy an insurance
contract on his car and potentially
profit if the car is damaged what was
option trading you can it's called
speculation now one last thing we've
only looked at one type of option a put
option which increases in value when the
value of the underlying asset decreases
however just as we discuss in the online
course there's another type of option
called a call option this option gains
in value when the underlying asset
increases in value this illustrates an
important feature of options trading
which is the ability to use strategies
for however you feel the mark will move
up down or sideways
hopefully this analogy helps you grasp
some of the core concepts of options
namely how option pricing works and the
relationship between the underlying and
the contract
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