I have been discussing the stock market with some of my friends and a lot of them have come to me with a similar question and that is "What exactly is being traded on the stock market?" Some are asking me "What is the difference between buying stocks and buying stock options?" It seems that I have kind of jumped the gun by talking about trading stocks before even discussing what is the stock market or what are stock options. I hope with this post I can give my friends and followers of the blog (Oh I notice I have a few now!) a better idea of what stock option trading is all about.
I think most people understand that when you buy stock options you are not buying a physical object like a television set or a house. You are buying a contract. A contract is always written to be used as an agreement between two people. So in this case the contract is an agreement between the company and you, the buyer. The contract is that by buying the stock you do not own a part of the company but you own the rights to a contract that can be bought to own a part of the company. Stocks are actual ownership of a percentage of the company but stock options are just contracts to the rights to buy a percentage of the company.
So let's think for a moment okay. Let's not get ahead of ourselves. If you can understand the concept of someone that is involved in real estate that buys lots of homes only to resell them for profit, then you can understand the concept of buying stock options. If for example as the case in Taiwan, a new High Speed Rail was built. Those interested in making money with real estate realized that the land and homes located nearest to the new high speed rail would become more valuable because not they would be accessible by more people, businesses, etc. so many people bought them up. Does that mean they are going to live in all those homes? No. They are making a profit. The same goes with the stock options. You buy the stock not really to become a part of the company but to later sell it to others for a profit. Does a buy always lead to profit? No, but the mindset going into the deal is with hopes that it will lead to profit.
Now let me go a bit deeper into the idea of stock options trading with my analogy of the land near the Taiwan High Speed Rail.
Imagine for a minute that the Taiwan High Speed Railway has not been built yet but you know it will be built in the future; actually it will be started in 2 years and probably finished 5 years later. Actually you eye a piece of land that you suspect will be used for the High Speed Railway but you have no idea if it will truly be utilized or not for the railway, but you have a hunch that it will be. The main reason you have this hunch is that you know there are plans to have a stop in a particular city but you're not for sure where. You suspect since this spot is out in the country that it is a good location for the Taiwan High Speed Railway. So you approach the person that owns the land and ask them to sell you the rights to buy the land anytime within the next 10 years for the price that it is valued at today, which we can say is $50,000US. The owner agrees and you pay the owner $5,000US for the contract or rights to buy this land within the next 10 years.
You wait two years later and as it turns out the land you bought is nearby the stop for that city. It's not too close so it will not disturb the residents, yet it's close enough to allow people to easily commute to the railway to arrive at Taiwan's famous Taipei City. You've just made a bucket load of money. At the time you approached the owner of the land, you bought the rights to the property for $5,000US and at the time the value was at $50,000US but do you think after the Taiwan High Speed Rail was installed that it is still valued at $50,000US? No, it's now worth $200,000US. So if you paid the owner the $50,000US, you still make a profit of $145,000US. Not bad, eh?
So what could you do with your land? Well you could keep the land (but you have a nice home in Taipei City already) or you could sell the land on the market right? That would still give you a nice $145,000US bonus. In order to do this though you would need to have the $50,000US to first buy the land then and only then be able to sell the land for profit. Or you could do something else...
If you do not have the money to buy the land first and then resell it, you could simply sell your contract that you purchased for $5,000US to someone else for a higher price. You've already paid the $5,000US and already have the rights to this land. Therefore, you could not sell the land itself because it still belongs to the original owner but you could sell the rights to purchase the land to someone else and you could do it for profit! So instead of buying the land (you don't need it or you don't have the money to do it), you sell the contract to a big real estate firm for $100,000US, making a big profit of $95,000US and are very happy to do so!
So now I think you have a better idea of what it means to buy stocks, or to be an options trader in the stock market. What you're essentially doing with options trading is buying and selling contracts and of course this can be very profitable! Any questions?
So what would you do if you were investing? You would try to find a stock that you knew through research was going to increase in price in the future. (We will talk about this more in detail later or you can view my earlier posts for some simple examples.) Then when it increases in price, you sell it for profit and walk away a happy person!
I think most people understand that when you buy stock options you are not buying a physical object like a television set or a house. You are buying a contract. A contract is always written to be used as an agreement between two people. So in this case the contract is an agreement between the company and you, the buyer. The contract is that by buying the stock you do not own a part of the company but you own the rights to a contract that can be bought to own a part of the company. Stocks are actual ownership of a percentage of the company but stock options are just contracts to the rights to buy a percentage of the company.
So let's think for a moment okay. Let's not get ahead of ourselves. If you can understand the concept of someone that is involved in real estate that buys lots of homes only to resell them for profit, then you can understand the concept of buying stock options. If for example as the case in Taiwan, a new High Speed Rail was built. Those interested in making money with real estate realized that the land and homes located nearest to the new high speed rail would become more valuable because not they would be accessible by more people, businesses, etc. so many people bought them up. Does that mean they are going to live in all those homes? No. They are making a profit. The same goes with the stock options. You buy the stock not really to become a part of the company but to later sell it to others for a profit. Does a buy always lead to profit? No, but the mindset going into the deal is with hopes that it will lead to profit.
Now let me go a bit deeper into the idea of stock options trading with my analogy of the land near the Taiwan High Speed Rail.
Imagine for a minute that the Taiwan High Speed Railway has not been built yet but you know it will be built in the future; actually it will be started in 2 years and probably finished 5 years later. Actually you eye a piece of land that you suspect will be used for the High Speed Railway but you have no idea if it will truly be utilized or not for the railway, but you have a hunch that it will be. The main reason you have this hunch is that you know there are plans to have a stop in a particular city but you're not for sure where. You suspect since this spot is out in the country that it is a good location for the Taiwan High Speed Railway. So you approach the person that owns the land and ask them to sell you the rights to buy the land anytime within the next 10 years for the price that it is valued at today, which we can say is $50,000US. The owner agrees and you pay the owner $5,000US for the contract or rights to buy this land within the next 10 years.
You wait two years later and as it turns out the land you bought is nearby the stop for that city. It's not too close so it will not disturb the residents, yet it's close enough to allow people to easily commute to the railway to arrive at Taiwan's famous Taipei City. You've just made a bucket load of money. At the time you approached the owner of the land, you bought the rights to the property for $5,000US and at the time the value was at $50,000US but do you think after the Taiwan High Speed Rail was installed that it is still valued at $50,000US? No, it's now worth $200,000US. So if you paid the owner the $50,000US, you still make a profit of $145,000US. Not bad, eh?
So what could you do with your land? Well you could keep the land (but you have a nice home in Taipei City already) or you could sell the land on the market right? That would still give you a nice $145,000US bonus. In order to do this though you would need to have the $50,000US to first buy the land then and only then be able to sell the land for profit. Or you could do something else...
If you do not have the money to buy the land first and then resell it, you could simply sell your contract that you purchased for $5,000US to someone else for a higher price. You've already paid the $5,000US and already have the rights to this land. Therefore, you could not sell the land itself because it still belongs to the original owner but you could sell the rights to purchase the land to someone else and you could do it for profit! So instead of buying the land (you don't need it or you don't have the money to do it), you sell the contract to a big real estate firm for $100,000US, making a big profit of $95,000US and are very happy to do so!
So now I think you have a better idea of what it means to buy stocks, or to be an options trader in the stock market. What you're essentially doing with options trading is buying and selling contracts and of course this can be very profitable! Any questions?
So what would you do if you were investing? You would try to find a stock that you knew through research was going to increase in price in the future. (We will talk about this more in detail later or you can view my earlier posts for some simple examples.) Then when it increases in price, you sell it for profit and walk away a happy person!
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