Excuse the pun, but there are a lot of options when it comes to investing. Options themselves are a sort of investment vehicle. An option is a sort of financial derivative, or contract, that stipulates specific conditions. More or less, an option gives a buyer a right, but not an obligation, to purchase something at a specified price.
Don’t worry if you’re a bit confused. Options are among the more advanced financial instruments, at least as far as commonly traded ones go. Options give you the option to buy something at a predetermined price, that part is straight forward enough. But why would anyone buy or sell such a financial instrument? Read on to find out!
How Options Are Used
Options can be used in a variety of ways. Indeed, the variety of applications for options is probably what makes them so popular among professional traders. Options allow people to engage in speculative activities, or to hedge against certain developments.
So depending on the option contract a trader purchases, he or she can use them to hedge against uncertainty, or to ramp up uncertainty to increase the potential profits. Few other trading instruments are so versatile. To understand why, let’s take a closer look at what options actually are.
A person looking to protect his investments will use a “put” option. This will allow him or her to sell his or her stocks at a pre-agreed upon price (often the current market rate) should the value of the stock drop to a certain point. Call options give investors the right to buy a stock at a certain price (again often at the current trading price) should the stock rise to a certain point.
Demonstrating investment vehicles is usually easier than explaining, so let’s use an example. Let’s say Joe is convinced that the stock value of Acme Motors is set to increase by 25% over the next few months. Stocks are currently selling at $20 dollars. So Joe buys an “option” to buy 100 shares at $20 dollars and pays three hundred dollars for the option.
Joe’s intuition turns out to be correct and stock prices rise to $25 dollars. Now, Joe can opt to purchase the stocks at the purchase price, or more likely he can “offset” the stock and receive the difference. In this case, Joe would receive $500 dollars (minus the $300 dollar investment). The $200 dollar profit Joe secured on his investment is quite extraordinary given his initial investment of only $500 bucks.
Let’s say Suzy is a hedge fund manager and her fund owns 10,000 stocks in Acme Computers. She is worried, however, that the product launch of a rival could cause Acme’s stocks to head south. The stock is currently selling at $200 dollars, so the total value of her investment is $2,000,000 dollars. Let’s assume she is able to buy an option for $300,000 dollars to sell her stocks at $200 dollars within the next six months. Suzy’s intuition turns out to be correct and stock values for Acme Computers drop to $150 dollars. However, since Suzy hedged against the drop, her own losses are minimized.
Why Options Are a Good Option
One of the best parts about an option is that they allow you to invest without having to tie up huge amounts of money. If we go back to Joe who was able to buy an option for 100 stocks for only $300 dollars (this is hypothetical but close to what market prices often are). If he had wanted to buy the stocks outright, he would have needed to have $2,000 dollars on hand. So options can, in some circumstances, be a low cost option (pun intended).