An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.
Still confused? The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of £200,000. The owner agrees, but for this option, you pay a price of £3,000.
Now, consider two theoretical situations that might arise:
1. It's discovered that the house is actually the true birthplace of John Lennon! As a result, the market value of the house skyrockets to £1 million. Because the owner sold you the option, he is obligated to sell you the house for £200,000. In the end, you stand to make a profit of £797,000 (£1 million - £200,000 - £3,000).
2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VIII haunts the master bedroom; furthermore, a family of super-intelligent rats have built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the £3,000 price of the option.
This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a currency pair, commodity, share or an index – a tradable security.
Calls and Puts
The two types of options are CALLs and PUTs:
1. a CALL gives the holder the right to buy an asset at a certain price within a specific period of time. CALLs are similar to having a long position on a share. Buyers of CALLs hope that the security will increase substantially before the option expires.
2. A PUT gives the holder the right to sell an asset at a certain price within a specific period of time. PUTs are very similar to having a short position on a stock. Buyers of PUTs hope that the price of the security will fall before the option expires.
There are two main reasons why an investor would use options: to speculate and to hedge.
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. There are clear benefits of speculating using options, such as the limited risks (no matter where the market goes your maximum risk is the premium paid on open), and therefore no stop-loss required (never get stopped out), no daily rolling fees to hold the position, profit potential is uncapped, you can profit from a move in your direction but also from an increase in market volatility, you can build strategies to trade price movements in different ways to just buying or selling.
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. Most options traders work on the assumption that if they take 10 options only 1 or 2 will work out, but they are banking on those which do work leading to profits which offset the losses on the rest.
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.