Why Use Options?

There are two main reasons why an investor would use options: to speculate and to hedge.

Speculation

You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.

Speculation is the territory in which the big money is made - and lost. The use of options in this manner is the reason options have the reputation of being risky. This is because when you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions! The combinations of these factors means the odds are stacked against you.

So why do people speculate with options if the odds are so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.

Hedging

The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine that you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way.

What Are The Different Kinds Of Options?

This can be expanded on as follows: Long call – If a market speculator thinks an assets price is going to increase they may buy a call option which gives a right to purchase the asset as opposed to just buying the asset itself. There is not an obligation to buy the asset but there is a right to buy it, this right is no longer there after the expiration date. If at expiration the underlying asset price is over the exercise price the speculator will profit if price is over by more than the premium paid. However, if the asset price on expiration of the option is under the exercise price the call will then be worthless on expiry and the premium will be lost.

 

Long Put

For speculators who think that an asset’s price is going to decrease. The trader can buy the right to sell the asset at a pre-determined price. If the trade goes wrong the long put buyer can lose the premium but the loss is limited to the premium. This can be confusing as going long is usually synonymous with buying an asset.

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Short Call

For speculators who likewise think that an asset’s price is going to decrease they can sell an asset short or write a call. This kind of option has unlimited potential for losses unlike the long put.

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Short Put

This is simply the sale of a put option, These are often used when the trader is bullish in terms of market direction but bearish on volatility. Losses on a Short Put are unlimited in a falling market.

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