An option is a contract that gives the holder the right to buy or sell a specified amount of stock (or sometimes another security) at a specified price (called the strike price) until the date the option expires. However, the holder isn’t obligated to actually exercise the option. Options trading has the reputation of being a speculative and very risky form of securities trading. While much options trading is speculative and high risk, it is also used to limit risk by traders in the stock or other underlying security.
Options that give the holder the right to buy the underlying security are called call options. Options to sell are referred to as put options. There are two basic approaches to options trading. Hedgers use put options to limit potential loss if the underlying security declines in value. Speculators trade options in hopes of anticipating the price movement of the underlying security and making a large profit. The advantage to both hedgers and speculators is that options are a way of leveraging the stock. That is, the options contract guarantees the strike price, but costs far less than purchasing (or short selling) the actual stock. The cost to the hedger is relatively small. For the speculator, leveraging creates the potential for large profits.
Traders may be either buyers (“holders”) of options contracts or sellers (“writers”). The main difference is that the company or individual who writes (sells) the contract is obligated to buy or sell the stock if the option is exercised. Options writers charge a premium to offset the potential cost. There are several types of options contracts. Listed options are those traded on an exchange like the Chicago Board of Options Exchange. They include short-term options which expire after just a few months and “LEAPS” (long-term equity anticipation securities) which last for one year or more. Exotic options with non-standard contracts are often traded over-the-counter. There are also options contracts for securities other than stocks such as index options and foreign currency exchange options.
Institutional traders and individuals use options for hedging. A hedger has a position (owns) some security, usually shares of stock. In order to limit the potential for loss if the stock declines in price, the hedger can buy put options for the stock. In this way, potential losses are reduced because if the stock does fall in price, the option guarantees the hedger the right to sell at the strike price until the expiration date. The maximum loss is the difference (if any) between the price paid for the stock and the strike price.
Speculating on options is the trading strategy that is high-risk (and potentially high-profit). For example, an options trader might purchase a call option for 100 shares of a stock selling at $28 per share (100 shares is the standard contract) with a strike price of $25 per share. The option will cost $3 per share (the difference between the share price and the strike price, called the intrinsic value) plus the premium. All together, the option price might be $3.50 per share. The option trader is betting the price of the stock will increase enough to be “in the money.” The profit potential is high. A modest gain of $3 to $3.50 per share doubles the trader’s money. The risk is also high. If the stock falls a few below the strike price, the option is worthless. Put options work the same way, only the trader gains if the stock falls in price.
Options trading is complex, partly because options are a derivative security whose value depends on the price behavior of the underlying security and partly because of the complexities of hedging or speculating in options. Some investors prefer to avoid the risks of speculating in options. It’s worthwhile to learn how options work anyway. They are an excellent tool for protecting investments by limiting the downside risk.