The Real Estate Analogy
OK, enough with formal definitions, let’s look at the analogy to better understand a call option contract. For example; an option contract in real estate between the current real estate owner and a prospective real estate buyer.
Let’s assume the owner has a property that is fairly valued at $100,000. It is in an up and coming real estate area. The owner does not want to sell the house at this price and therefore takes the home off the market. The owner would, however, like to sell if the price would increase to $110,000.
The second party in this example is a real estate investor. He believes that prices in this area will rise in value, but there is a limited supply of houses for sale. The investor, therefore, requests to buy an option from the homeowner. The option will give him the right to buy the house at $110,000 target price from the owner at any point during the next 2 years.
From the owners perspective, this is a compelling offer. Because she is targeting to sell when the home reaches $110,000 in value. Additionally, the owner gets to collect additional money from the option contract. She keeps this money whether the investor exercises his right of the option contract in the next two years or not.
After a few iterations, the buyer and seller agree on an option price of $2000. The investor gives the current homeowner $2000. And the owner gives the investor the option contract.
Fast-Forward: Let’s look at four different scenarios
Let’s fast-forward two years and look at 4 different scenarios:
- The price decreases to $90,000. In this case, the investor was wrong in their speculation and lost the full $2000 paid to the homeowner. The homeowner has also lost $10,000 off the value of her home. But her total loss is reduces to $8,000 as she keeps the $2,000 from the option contract.
- The price only increases a little to say, $102,000. In this case, the investor has lost the full $2,000. Of course, he would be crazy to buy the house for $110,000 when its value is only $102,000. The homeowner net worth increases by $4000. $2000 appreciate the home value + $2000 that she collects from the options contract.
- The home’s value increases to the break-even price of the options contract or $112,000. How did we get to $112,000 and not the contract agreed price of $110,000? Because that’s the price where neither party loses money. For example, actual money paid for the option from the investor or lost upside value in the home. That amount is taken by the investor and cannot be realized by the homeowner. If the home’s value is $112k after 2 years then the investor will buy the home for $110k and sell the home for $112k. Netting $2,000, which is equal the original amount of his investment. The buyer has made their target return of $10k plus gets to keep a bonus $2k on top. It would be the same as if they sold the house without the option contract at $112,000.
- The final scenario is where the investor is right. Let’s say the home increases in value to $120k. In this case, the homeowner would have to sell their house $10k under market value. She collects $2000 upfront from the investor to give him the option to buy the home for $110k. This isn’t all bad because the homeowner still made her target return of $10k. She also gets to keep the option contract premium ($2000) for a total of $12000 return. The investor gets to capitalize on the difference. He buys the house with his option contract at $110 and immediately resells the house at $120k. He receives a $10k profit less the $2k he paid initially. In this case, he turns $2000 into $10,000 in 5 years for a tidy return of 500%.
Relating it back to Options Trading
To relate this example back to a standard options contract:
- Strike Price : The agreed price at which the investor can buy the house from the owner.
- Call Contract : The house is analogous to the stock that the investor can buy at a price they agree upon in the contract.
- Stock Owner : Homeowner.
- Speculator : The real estate investor.
- Premium : The $2000 transferred from the investor to the homeowner for the option contract.
- Expiration Date : 2 years from the date of the option contract.
Is it better to be the Homeowner or the Real Estate Speculator?
Bonus: We believe it’s better to be the home buyer or the option seller in the example above. Unlock below.
At OptionAutomator we focus on strategies of the homeowner and cater to the real estate investor (speculator). There’s a very simple reason why. Because in 3 out of the 4 scenarios above, the homeowner made out better than the speculator.
While the speculator can occasionally walk away with a big payday, this is, by definition, an abnormal market move. We’ll discuss more on probabilities and how we can predict the probability of a trade later on. However, it is not how we should trade regularly.
OptionAutomator will help you trade regularly and consistently. We encourage our users to engage regularly and consistently in the higher probability trades.