Basics of Options (Explained via Analogies)by Siam Luu
The best way to think of options are like coupons that you can buy or sell. Imagine a store that sells something to the mass public and has plans to sell a new product. Nobody knows how much the new product (called 'Gidget') is going to cost yet but taking action, the store is selling coupons (say for $1-3) that would give the holder of the coupon the right to purchase the product for a set price (say $100). The coupons come in a few different varieties, including but not limited to: the ones where you can give it to others, the ones where you keep for yourself, or the ones that you can redeem early if the store gets a certain number of Gidgets in advance. When the time comes to sell the Gidgets, if the store sells Gidgets for $75, you don't use the coupon because it doesn't make sense to pay $100 for something that is selling for $75. Thus, it's a sunk cost. However, if the Gidget is selling for $150, you made a wise choice of buying that coupon early because you can now buy the Gidget for $100, sell it to somebody else for $150 and use your profit to go back and buy a brand new Gidget altogether. Mathematically, it works like this: -1-100+150-100=-51. Therefore, you paid $51 dollars total for the Gidget, thanks to that coupon or "option" that you bought before the Gidget ever launched. If you didn't use the coupon because the Gidget was selling for $75, the math works out to: -1-75=-76. In this case, you are paying a little bit more than everybody else, but you are okay with that because you knew exactly what you would have had to pay regardless of everybody else. This is very basic.