Papale on the Fundamentals

Ok, maybe there is something to this global warming after all.  I read that last year was the warmest year on record in the Chicago area.  And now this weekend they are predicting 60 degrees.  That’s 60 in January.  In Chicago.  My 11 year old is not too happy though.  He got some new hockey skates for Christmas and is dying to get out on the outdoor rink with his friends and try them out.   Not this weekend.  I guess we need to go to the indoor rink again.  But I want to spend some time outdoors too.  Maybe we will have a picnic.

Like a successful athlete, it is sometimes good to go back and review the fundamentals.  We can get caught up in lots of information and theory but let’s spend some time just reviewing the basics.  Options are financial instruments known as derivatives.  What this means is that options derive their value from some other underlying instrument or factor.  For example, a farmer may buy insurance on his crops that pays him a specified amount if the weather is bad for growing.  If the weather is good and he produces a plentiful crop, he does not get paid anything and is only out the cost of the insurance policy.

Options come in two varieties – calls and puts. Both derive their values from some underlying asset – such as a stock, commodity, future or ETF.  So as the underlying moves up or down in price, the value of the call or put changes.  Calls are rights to buy the underlying at a predetermined price over a specified time period and tend to rise in value as the underlying goes up and fall as the underlying price goes down.  Puts, on the other hand, are rights to sell the underlying at a predetermined price over a specified time period and tend to fall as the underlying price goes up and rise as the underlying goes down.  If you own a house or car and have insurance you have a kind of put.  You pay the insurance company a fee and if your car or house gets damaged you collect dollars based on the value of the car or house.

Next week, we will delve in deeper to calls and puts.

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