Options: The Power Lies In Their Versatility
Most investors invest in stocks, ETFs, mutual funds and bonds. How about adding another type of security called Options to your portfolio ? If you are new to the world of options trading, read on…
The power of options lies in their versatility. They give you the power the adjust your position according to the present situation. However just like any other security, options have their own set of problems. Options are complex securities and can be sometimes extremely risky. Option trading is therefore not for everyone.
However before you decide not to trade in options, you should atleast understand them. Not learning how options function is as dangerous as jumping right in it.
What is an Option
Option is nothing but a contract that gives the buyer the right to buy/sell an asset at a specific price on/before a certain date. So what is the big deal about that ? The big deal is that the buyer is not obliged to buy/sell. Now that sounds interesting….isnt it ?
Investopedia gives an excellent example.
Say, 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:
- It’s discovered that the house is actually the true birthplace of Elvis! 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).
- While touring the house, you discover not only that the walls are chock-full of asbestos, 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.
Calls and Puts
The two types of options are calls and puts:
A call gives the holder the right to buy an asset at a certain price within a specific period of time. Buyers of calls hope that the stock will increase substantially before the option expires.
A put gives the holder the right to sell an asset at a certain price within a specific period of time. Buyers of puts hope that the price of the stock will fall before the option expires.
People who buy options are called holders and those who sell options are called writers. Holders have the right to buy/sell but are not obligated. Writers are however obligated to buy/sell. This makes selling options more complicated and even riskier.
Why Investors use Options ?
Investors use options to both speculate and to hedge risk. Speculation in nothing but betting on the movement of a security. The advantage of options is that due to their versatility you can make money even when the market is crashing. Think of hedging as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn.
Types of Options
There are two main types of options.
- American options can be exercised at any time between the date of purchase and the expiration date.
- European options can only be exercised at the end of their lives.
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