The typical investor’s portfolio consists of stocks, bonds, and mutual funds, but other types of securities are available for increasing diversification. Many sophisticated investors rely on options to create new opportunities within their portfolios. Options are extremely versatile securities that can help investors shift their market position to hedge risk and even engage in speculative activity.
At the same time, options are complex and present a number of risks, especially if individuals do not thoroughly understand how to use them. Even if individuals do not want to use options themselves, they should make an attempt to understand them if the companies they invest in rely on them.
What, Exactly, Is an Option?
An option is a derivative security, meaning that its price is based on other financial assets. An option is essentially a contract that provides the right, although not the obligation, to purchase the underlying asset at a certain price within a certain time frame. Investors refer to the right to sell as a put option and the right to buy as a call option.
A put option can be considered a sort of insurance policy. If the market falls, having a put option can empower investors to sell stocks above their market value to minimize the loss. At the same time, purchasing a put option involves a certain cost that is lost if the market does not drop during the set period.
A call option is sort of like a deposit for the future. Individuals pay a premium to secure the right to purchase an asset with the hope that the asset’s value increases during that period. Purchasing the asset at a lower price provides an immediate gain. Again, the premium is lost if the right is not exercised.
When purchasing options, investors will find a range of new and sometimes confusing terms. For example, the term “strike price” refers to the price of the underlying asset. Asset prices must go above the strike price for calls or below the strike price for puts to result in profit. An option is “in-the-money” if the strike price is below the share price for a put, and the difference is referred to as the “intrinsic value” of the option. Options must be exercised before the expiration date, or expiry, which is clearly set in the option contract.
What Types of Options Exist?
In addition to call and put options, several other categories exist that investors should understand. American options, for example, come with the right to be exercise at any point between the purchase of the contract and the expiration date. This type is the most common option. However, European options also exist, and these varieties can only be exercised on the expiration date.
Despite the names, these two different types of options have nothing to do with geography, but rather only the right to exercise the option early or not. European options are common on stock indices and typically come with a lower premium, since they have less flexibility.
Some options are traded on public exchanges. These options are referred to as listed options. Several physical and electronic exchanges exist in the United States for trading options. Options contracts traded directly between two people are called over-the-counter options.
The term exotic option refers to variations on standard contracts that can often be wildly different financial products as long as they have some degree of “option” in them. Common exotic options include lookback options, barrier options, Asian options, and Bermudan options. Typically, everyday investors stick with standard contracts.
How Can Options Be Used?
Investors can use options for a wide range of purposes, but there are three clear advantages of these contracts. The first major use is hedging. Options can reduce risk when they are used like an insurance policy to protect against market downturns. Some investors say that people should not purchase a stock if they are unsure of its future, but options are a great method for limiting losses while enjoying the upside of certain industries, such as the technology sector.
Some individuals use options for speculative purposes. Individuals bet on the future price of an asset by purchasing an option that would make them money if the asset price moves in the expected direction. For example, an investor may purchase a stock option at a low price, exercise the option when the stock increases in value, and then sell the stocks at the higher value for an immediate gain. Purchasing an option rather than the stock is attractive because it typically costs much less money and provides some leverage.
People can also engage in spreading, which involves having a speculative and hedging option to benefit from any change in asset price. While this strategy limits income potential, it also limits risk. A special type of spreading is called a synthetic, which creates a certain market position without actually owning an asset.
For example, individuals may buy a call and also sell a put with the same strike and expiration, which is similar to holding the underlying asset. This strategy is most valuable when the underlying asset is difficult to construct, such as an index.