Yes, that’s a picture of me in my early 20’s working on my first big Hollywood film Harry Potter and the Sorcerer’s Stone. I took crew, photos with my roommate’s lighting kit. And that hat on my head is the actual sorting hat from the movie. The company I worked for made it talk in CG. And if you know me, I love dancing like Michael Jackson, so what better way than combining the 2:)

Anyway, back to the point of the article… Options trading can seem daunting and very confusing. I hope this made-up story using Harry Potter characters helps you better understand how options trades work. Enjoy…

Ron Weasley is a poor wizard. He wants to buy a new cloak hanging in the store window on Diagon Alley. His mother had sent him an old hand-me-down cover for the ball, but he is embarrassed to wear it. So he goes into the store and puts a small amount of money down on the cloak (puts it on layaway) in hopes that he can come up with the rest of the money in the agreed-upon time with the store owner. The agreement was, if he didn’t cover the rest of the price within two months, Ron would not only miss out on the cloak but will lose the money he put down on the cloak. Ron was given the slip of paper with the agreement to purchase the veil for the agreed-upon price within a specific time frame of 2 months.

Then, the famous wizard Professor Gilderoy Lockhart was seen wearing this same cloak the next day. The entire magic community wanted to get a hold of this cloak. So the price of these cloaks skyrocketed with demand. There is a line out the door of the same store that Ron put this cloak on layaway. Many of these people won’t have the opportunity to buy the veil because there aren’t enough of them to purchase.

But Ron has a ticket to buy this cloak for the original price before it skyrocketed in price! So he exchanges the token with someone in the back of the line for the new price of the cloak, minus the remaining amount owed to the clerk on layaway. So Ron keeps the spread, and the person in line is happy to get the veil even though it’s a much higher price than Ron would purchase it.

Now Ron just made a bunch of money and can buy another less famous, less excited cloak, and still look good for the ball.

This is precisely how options trading works. Someone purchases the right to own stock within a specific time frame for a small fee. If they don’t pay the total price within that time frame, they lose their small fee for holding the stock. If the price goes up, then that person can exchange their agreement with someone willing to pay the higher price, and now they just made money by keeping the spread.

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