Why use options?

Hello and welcome back to the blog. I have said in my previous post that we will learn about how to choose a proper option in this post. I realized that it would be way ahead of our learning curve. So let us get more insights into the basics of options by learning why use options in this post.

Two major uses of options are; speculation and hedge.

Speculation:

Option trading is used as a speculation when an investor thinks of benefiting from the movement in the price of a stock. The advantage of using options is you are not limited to making profits only when the stock price moves up. Since, the options are so versatile you can make money when price of a stock goes up, down or even sideways.

You buy a call option on any stock when you think it is going to move up and then profit from the move.

You buy a put option if you think the price of a stock is moving down to profit from the move.

A third way to make money using options by selling options if you think the price of the stock will not go anywhere and stays sideways.

Due to this versatility of options investors have a chance to gain as well a big money as they can lose. Speculation is the main reason options are termed very risky investing instruments. This is because when you buy or sell an option not only that you have to be correct on the direction (up or down) of the price move but also on the timing (how soon or late the move will happen) and magnitude (how much the price will move). And of course throw in the factor of commissions, the odds of making money trading options is stacked up against you.

So, why do we speculate trading options, if the odds are so skewed? There comes the factor of leverage. Apart from the versatility, options provide what is known as leverage by way of controlling 100 shares with one contract. So, it helps in making a lot of money even with a small change in the price of a stock.

Hedging:

This is another function of option. Hedging is similar to buying insurance on house or car. When you a particular stock and want to protect your investment from the downside movement on the stock you may want to buy some put options to limit your exposure to the losses occurring from the downside move in the stock, though there is an argument against hedging for the reason you should not invest in a stock you think will move down. But then this is a better strategy if you want to get the full potential of upward gains while limiting your exposure to downside.

Another function of options is known as employee stock options given by some employers in order to keep their smart and talented employees from jumping off the company. This is similar to the regular stock option where the holder has a right but not the obligation to buy the company stock but this contract is between the company and the employee where as a normal option is a contract between two individuals that are completely unrelated to the company.

That’s in a nutshell about the uses of options and when a particular kind of option is used. More about the usefulness of options and the different outcomes of an options purchase in the next post. Mean while you can go to previous posts to learn about basics of options. Don’t forget bookmark this page and comeback for the updates for you options learning experience.