 Hey guys, it's MJ the student act tree and in this video. We're talking subject CT to chapter 5 Now in the previous video I went into quite a long explanation between a forward and a future contract So if you're interested on that go check out that video This video is gonna be focusing around what an option is and if we've got time I might even talk about a swap or I might make a separate video. Let's see how we go so The physical the definition for an option is an option gives an investor the right But not the obligation to buy or sell a specified asset on a specified future date But all the information is contained in that word option I Have the option if I come to you and I say do you want apples or do you want oranges? You have the option to either take the orange or to take the apple when it comes to the financial world we create these options and What it comes they they can be used to hedge or they can be used to speculate Let me give you a quick little example Let's say we have a business What should our business be our business is selling shoes let's say we selling shoes and We've got a little factory going and there's people getting the leather in they're knitting the shoes up and it's going great And the value of the company is at one million one million rent and What we do is we go to an investor and we sell that investor That we will give them an option to buy this business at 1.5 million rent so at half a million more and What we say to the investor is that Pay us a premium now and we will create this contract And what that means is that if the price of the company stays at one million or only goes up to one point four million in the following year Then that option Kind of becomes worthless in the sense that why should I buy it at 1.5 million when I can rather just go buy it on the market for 1.4 Where the option makes sense is let's say the shoe company does phenomenally well, and it is now valued at 2 million rent the investor can then exercise his option His option to buy because he's locked in the price at 1.5 million So he then goes and he says okay. I want to buy the shoe factory at 1.5 million or He can take this option and sell it to another investor who's interested in the shoe factory and make 500,000 rand on that deal because he's set the price at 1.5 million and the actual price of the asset now is 2 million and you can see there's half a million difference between it Now the important thing to realize is that it gives the investor the right but not the obligation so in this instance the Investor who has this option has got an unlimited upside risk So if it's for 2 million, he makes half a million if it's for 3 million He makes 1.5 million if it's for 4 million. He makes 2.5 million You can see no matter and there's there's no limit on how well the shoe factory could do For all we know Victoria Beckham could buy the shoes. She's walking down the street people see that shoes Everybody wants that shoe it becomes the new fashion or trend and the value could skyrocket So the investor has unlimited upside potential. It's it's amazing and at the same time if the shoe factory crashes or burns or The shoes nobody likes them and the company becomes absolutely worthless The investor doesn't have to exercise the right to purchase the shoe factory and So he's downside risk is limited Now this sounds a little bit too good to be true You've got all the the benefits of getting the upside But your downside is is limited in the sense that you don't lose money after you've bought an option But this is where the key thing comes in is that the option No one's just gonna write an option for you free of charge the the shoe shop owner or the current business owner isn't just gonna Give you an option out of the goodness of his heart In return he wants something known as a premium and in this case I mean the premium could be a hundred thousand Rand So the shareholder says okay, I'm gonna give a hundred thousand Rand to the shoe guy and This is gonna therefore allow me to have this option, which I can then exercise The option normally has an expiry date. So it might only be for one year So after one year if the value of the shoe factory is not greater than 1.5 million It means you cannot exercise the option and the share investor has lost that hundred thousand So that is the the downside of options is that you do have to pay a premium for them And when an option is built around the idea of purchasing an asset We call that a call option. So a call option gives you the ability To buy an asset now there's something else known as a put option So a put option gives the holder the right but not the obligation to sell an asset At a specific price within a certain time period So our shoe shop factory owner could approach an investor And say hey Why don't I buy a put option from you So what I will do I will give you the investor A bunch of money. Let's call it the premium in exchange for this contract Which gives me the right but not the obligation to sell my shoe factory at a specific price So let's say again at 1.5 million And what happens now is that let's say I'm the shoe shop owner and my company does very well Victoria Beckham's wearing it and the value of the company is at three million Then I'm basically going to tear up that put option and say you know what I don't need it My company is worth much more selling it on the open market for three million than exercising that option However, if something bad happens to my shoe factory, it burns down or nobody wants the shoes And it goes to say a value of just a hundred thousand I can then go to that investor and exercise this right to say hey We agreed that you would buy this shoe factory At 1.5 million. I'm exercising that right. Give me the money here are the keys to the factory And how this works by buying a put option I know What I still have is I have this protection if if my company comes worth lots and lots and lots of money I can still benefit from all of that But I've reduced the downside risk. So if my company comes worthless, I can now exercise this put option And make sure I get a certain amount back Although in this instance an investor is going to be very hesitant In order to to sell you this this type of deal unless you pay him a significantly high enough premium And that's where a lot of these exchanges make their money is that they charge quite a bit for these premiums And one way you can make money as an exchange is you sell a call option And you sell a put option and you put a little bit of admin fees in that premium amount Which means no matter if the shoe factory goes up or if the shoe factory goes down You just locking in the premium amount and this is where a lot of exchanges Make their money But that is option contracts. I mean this has just been an audio talk about a simple example I have made videos on options I think it's under the playlist for ca1 if you are interested in the stuff Go check out those videos to get a better understanding. I will put a description in Sorry, I will put a link in the description below. Thanks so much for listening guys. Cheers