What is an option?

"J"'s comment is the most accurate. Most of the posters keep saying an option has to do with stocks. Stock options are only 1 type of option.

In a nutshell an option gives the options buyer the right, but not the obligation to purchase the asset within a specified period of time at a specified price. Most people are saying stocks, so let's use stocks as an example.

Let's say you are holding a Dec. 2006 call option on XYZ Corp. with a strike price of 55 and XYZ Corp. is trading at $52/share. What that means is that you have the right to purchase XYZ Corp. stock at $55 per share on or before Dec. 2006 (if it's an American Style option, you can exercise the option anytime before expiration, if it's European style, you can only exercise the option on the expiration day). That means, you can purchase the stock for $55, but you'd want to wait till the stock is actually trading above $55. Let' say it rallies to $58/share. When you exercise the option, the option seller is obligated to sell the stock to you at $55 (the strike price is 55) even though the stock is trading at $58.

This is a very simplistic explanation as a put option would obligate the option seller to buy the stock from you at the strike price.

Options can be written on anything, stocks, commodities, real estate, etc. All an option is is a contract giving the buyer of the option the right to purchase the asset as a certain price within a certain time. If you have a real estate option on a house to purchase that house for $200,000 in 6 months, if you don't exercise the option, then it expires. But, if you exercise the option, the homeowner is obligated to sell you the house for $200,000, even if the value of the property has gone up to $275,000.

Now, for those people that are saying that people making money in options are either liars or lucky are clueless. They have probably never traded options in their life and have a minimal or no understanding of options and how they work.

When you trade options, you can either be an option buyer or option seller (or writer). The buyer is what most people are familiar with, but very few are familiar with an option seller. Anyone can be an option seller, you just have the funds to cover the margin.

The options buyer is the purchase the obviously buys the option. The option seller is the person that creates the option and sells it to the buyer. In a call option, the buyer is expecting the market to go up while the seller is expecting it to go down. On a put option, the buyer is expecting the market to go down and the seller is expecting the market to go up.

The buyer of the option makes money when the market goes in the direction they are expecting it to and the price of the underlying asset exceeds the strike price, or the premium of the option has rises higher than what they paid for it.

If you buy a Dec. 2006 call with a strike of 55, if the price of the underlying stock (in this example) is above $55/share, you'll make money. You can also make money if the premium goes up even if the price of the underlying is below the strike. Let's say you pay a premium of $250 for the Dec. 2006 with a strike of $55 and the underlying is trading at $52. You could have a quick up spike in price, say to $54.25/share. That would mean volatility has spiked and volatility is one of the major components of an options premium. That volatility spike could have pushed the premium to say $375. You can sell the option then an pocket a $125 profit per option.

The option seller makes his money buy selling the option to the buyer and collecting the premium. As time goes on the value of the option erodes as the time value of the option has a time decay factor. If the option does not move into the money by expiration date, then the option expires worthless and the seller keeps the entire premium.

So here's the scoop: For an option buyer, you have the potential of unlimited gains with limited risks (you can only lose the premium you paid). For the options writer/seller, you have very limited gains (you only can get the full premium paid for the option), but the risk are unlimited.

So, here's the question; guess which category the most successful options traders fall into - buyers or sellers? The answer ----- option SELLERS. Why? With options buying, you have to be right on 3 things: the direction of the move, the timing of the move and the magnitude of the move. Let's go back to our XYZ Corp. example. You have a Dec. 2006 call with a Strike of 55 and the underlying is trading at $52 per. What you are saying then is that you believe XYZ Corp. stock with rise (direction) by at lease $3 (magnitude) before or by the expiration date in Dec. 2006 (timing). If you are wrong on any one of those, you'll lose money.

With options selling, you are just working off the premise of "What is the probability that this option will expire worthless". Now, here's the meat of it all - statistically, 80%-90% of all options will expire worthless. What does that mean? If you're an options buyer, that means that you have a 10% to 20% chance of making money. As an options writer, you have a 80% to 90% chance of making money. The ones that consistently make money in options trading are the sellers as they take advantage of the fact that most options expire worthless.

I remember one options writing (selling) trade I took in gold. Prices made a quick move up and the program I was using state the current month call option had an 87% probability or expiring worthless by the expiration date. The option only had 2 days left till expiration and the premium was something like $285 (which means if I sold the option to someone, I'd get $285 for it). I looked at the price chart of gold and gold prices made a quick up spike. I've looked at enough price charts to know that a move like that usually will result in the asset falling in price over the next few days. So I wrote (sold) 10 call options for $285 each (remember for a call option, a buyer is expecting the price to go up while a seller/writer is expecting the price to go down, prices made an up spike, but a move like that will usually result in prices falling over the next few days) and received $2,850 in total premium. Of the next 2 days, prices did indeed go down and there was only 2 days left till expiration, so the option expired worthless and I kept the entire $2,850 premium paid to me. It took me less than 5 minutes to do the analysis and I pocketed almost $3000 in 2 days.

Now, before you go become an options writer, remember, it is a very risky trade. You can make money options buying also, but you have to be more astute than most people. Most people get caught up in the idea that you an make returns of 1000% or more with buying options. So, what do the morons do? They buy way out of the money options with expiration in 30 days or less and expect to make a killing because way out of the money options with 30 days or less till expiration are real cheap. So go back to the XYZ Corp. example. The stock is trading at $52 per, the moron will go buy an option that expires in 30 days or less at a strike price of something like 75. Which means the stock has to rise in price by $23 in 30 days or less. The chances of that happening are slim to none. You can make money options buying, but you need to buy options very close to being at the money or slightly in the money.

I know one gentleman that turn $1000 in $28,000 in about 3 months buying options. Here's how he did it. He would look at a stock or commodity and would observe the trend. If you look at the trend in any market, you will see that it doesn't right straight up or down, but moves in waves. Well, what he did was he'd find an asset (in this case commodities) that were definitely trending, when prices retraced a bit, he'd buy an at the money option and wait for the asset to resume it's primary trend.

For an example, let's say he was observing wheat and wheat was definitely in an uptrend. Wheat would move up to say $2.50 per bushel, then price would retrace to $2.25 a bushel. When it did that, he'd buy a call option on wheat at a strike of $2.25 (or the call option strike price closest to the price of what wheat was currently trading at). When wheat resumed it's uptrend, his options would be in the money and he'd sell the option for a profit. Granted an at the money option is more expensive than an out of the money option, but if you're making money, then so what.

The other posters are correct in that you should ask your brother how he's making money in options. But, don't let the other posters scare you off from options. BUT, do spend time studying and research and becoming familiar with options. Just like anything else, there is a learning curve and you need to become familiar with options trading. It takes time, patience and persistence.

I do trade options as well as futures and forex and I will tell you this, the people that I encounter that bad mouth options or futures or forex usually fall in one of these categories:

1) Haven't the first clue about them and think they are experts on the subject on the subject.

2) Have very little understanding of them and think they are experts on the subject.

3) Traded them with minimal knowledge and lost money and think they are experts on the subject.

It bothers me when people denounce something as risky when they don't understand it. Yet, these are the same people that will get in their cars, drive down the highway at 90 miles per hour with a cell phone to their head and won't think twice about the risk involved in what their doing. There is risk in anything you do. The key is not to avoid risk, but to manage risk. Sure, you can get in a car, drive the speed limit, turn your cell phone off so your not distracted and still get killed in a car accident, BUT the risk or likelyhood of that happening is far less than if you're speeding with a cell phone in one hand and coffee in the other.

Same thing with trading (whether its equities, options, future or forex), if you take the necessary steps to minimize your risk, yes you can still lose money, but it won't be as likely as if you didn't take the steps.

Let me ask you this, which is worse, to lose $5000 trading stocks or $5000 trading options? They're both bad and in this case it is immaterial how you lost it - that fact is you lost it. You can lose money in any investment.

I'll get off my soapbox now.