The Call Option Explained in Layman Terms

Let us say you have a friend Anand who wants to buy a house but does not have much money or has not yet established credit rating in the new place. Your other friend Aaron wants to sell his house and move into a bigger one because his family is growing. The market value of Aaron’s house is about $200k. You as a market maker, so to speak, invite them to dinner and propose a contract between the two as follows:

Anand will pay $5k to Aaron as a premium to lock the selling price and to hammer out a contract with Aaron that states that he (Anand) has the right to buy Aaron’s house at a price of $225k on or before a year from today. Anand will try his best to acquire the money for down payment and secure a loan to buy Aaron’s house.

Aaron’s feels that Anand will not be able acquire the necessary funds within a year so he eyes the $5K premium as an extra income to probably upgrade his house with. So Aaron states that should Anand fail to come up with the necessary funds on or before one year, the premium is his to keep.
Anand agrees with Aaron’s request, but wants the right to sell the contract to any third party before one year should that become necessary. This makes sense for Anand because, he sees the value of the house going up and if for some reason he could not come up with the money he can still sell the contract and make up the $5k or more which does not affect Aaron’s obligation to sell his house for $225 on or before one year.

You could make some arrangement with both of them to give you commission a flat fee for helping them hammer out a deal.

This transaction is a CALL OPTION.

Stock: The House

Current Stock Price: $200k

Premium: $5k

Strike Price: $225k

Expiration Date: one year from today
Aaron: Sells the CALL Option and collects the premium. He is obligated to sell his house to Anand at the strike price of $225k on or before one year from now. He is speculating that the house value is going up, but not over $225k and that Anand has no way of coming up with the funds required to buy the house, so that he can keep the premium of $5k for possible upgrades to his house.
Anand: Buys the CALL Option by paying the premium. He has the right to buy Aaron’s house at the agreed price of $225k within one year from today. He willing to forgo $5k premium if he couldn’t get the funds to buy the house before one year, but has the right to sell the contract to a third party should that become necessary. He is speculating that the house value is going up rapidly and if he couldn’t come up with the funds, he is still covered by the contract to sell his contract to a third party and get his $5k or more back. Anand breaks even when the house value goes up to $230k and profits if the house price goes beyond $230k even if he does not buy the house, by selling the contract to a third party because the contract value goes up with the house price.

You: The market maker. You can collect commission from both, Aaron and Anand for matching and coming up the deal.

The Put Option explained in Layman Terms

Suppose the housing market is going down due to impending interest rate hike and a perceived recession. Aaron’s house is currently worth $200k. Aaron is worried that his house may drop in value way below $200k and so wants to protect his investment. Aaron calls you and asks if anybody would be interested in writing a contract to buy his house at $150k within a year for which he could pay a premium of $5k. You contact your friend Anand who is looking to buy a house.
Anand thinks that he could afford the house at $150k and also likes the idea of getting a premium of $5k to do so. He is willing to take the risk of buying the house at $150k even if the house value falls well below that because he is going to keep the house for a long time.
This transaction is a PUT OPTION.

Stock: The House

Current Stock Price: $200k

Premium: $5k

Strike Price: $150k

Expiration Date: one year from today
Aaron: Buys the PUT Option and pays the premium for the insurance on the house price. He has the right to sell his house to Anand at the strike price of $150k on or before one year from now. He is speculating that the house value is going to drop way down below $150k due to impending interest rate hike and the following perceived recession, and that Anand will come up with the funds required to buy the house with in a year because he is desperately looking for one.
Anand: Sells the PUT Option by collecting the premium. He is obligated to buy Aaron’s house at the agreed price of $150k within one year from today, even if the value falls way below $150k. He will keep the $5k premium if the house value stays above $150k and he is not obligated to buy the house. He can, however, buy the contract back from the original buyer should that become necessary at a price greater than $5k. He is speculating that the house value is going to drop to about $150. Anand breaks even when the house value goes down to $145k and loses if the house price goes below $145k even if does not buy the house, by buying the contract back at a higher price than $5k. If he buys the house at $150k then his loss is the difference between the current price, say $140k, and $150k minus the premium, equal to $5k ($150 – $140 – $5k).
You: The market maker. You can collect commission from both, Aaron and Anand for matching and coming up the deal.