This is how a typical option contract works.
Stephen inherited his parents’ home and uses it for rental income. Mary Jo knows that Stephen would sell the house if he could receive $129,000 for it, but most buyers want to live in the house. Stephen needs the rental income, so he cannot afford to kick out the tenant while he markets the house for a sale. Stephen could put a clause in his lease allowing him to cancel the lease if he finds a buyer, but that would scare away many tenants. Stephen has a problem he does not know how to solve. Mary Jo knows an investor who might be interested in buying the house and who would be willing to pay $159,000.
Mary Jo has three problems: (1) she has no cash for a down payment; (2) she does not have the ability to borrow money for purchase and holding costs; and, (3) she has no experience managing tenants.
It is November, though, and Stephen would like some extra cash for the holidays. Mary Jo says to Stephen: “I will pay you $500 right now if you will sign a contract giving me the right to buy your property any time during the next six months for $129,000. The $500 is yours to keep, no matter what happens. But, if you change your mind about selling and want to refund the $500 and cancel the contract, you will not be allowed to do that. If I decide not to buy, I will have no obligation to you, but you still keep the $500.”
If Stephen agrees, Mary Jo will have six months to use her superior contacts, knowledge, and hard work to find a buyer willing to pay the more realistic fair market value of $159,000. She can buy the house and then resell it the same day, or she can simply sell her option to the buyer. Mary Jo will never have her name on the title, she will not go through a closing, and she will have no sale expenses.
At the end, she will make a return of $29,500 on a cash investment of only $500. Of course, she might not be able to pull it off. If she fails, she loses her $500, but no more. This type of risk can be managed easily by most people.