What Are Options?

You’ve undoubtedly seen commercials where the sales pitch contains some variance on the phrase “no obligation.” If this sales pitch stemmed from the stock market, there’s a decent chance the spokesperson would be discussing options. After all, the crux of this concept is based on the trader having the right to buying or selling an underlying asset at a specific price on or before a specific date, but not having an obligation to do so. It’s a concept that can be pretty complex, but for investors that love taking deep dives into sophisticated analytics, it can be pretty terrific.

What’s an Options Trader?

Options at a Glance

Options are alluring to investors because they offer a wealth of versatility. The investor can turn the strategy into a speculation fueled concept, or they can strip it down to its basics and play the long game on blue chips. It can be used as a means to protect the investor from decline, or it can be used as a means to go fully aggressive when the market is bullish. In other words, options allow the investor to play the market in a host of different ways.

This carte blanche may seem like the ideal way for novices to figure out what kind of market player they are, but don’t be fooled: this is a proposition that involves quite a bit of risk. Yes, it does allow one to shape and mold their strategy. But if they go at this concept blindly without a firm grasp on how to analyze each option path, they could end up in a world of hurt.

Right vs. Obligation

Perhaps the most important thing to keep in mind when we’re talking about options is the ability to differentiate between right and duty. With an option, the investor can act on the buying or selling of an underlying asset by a certain date if they so choose. This also gives them the capacity to turn their back on the underlying asset if they aren’t satisfied with its performance on that date. This lack of obligation to act on an option will cost the investor the money spent on the option, but this cost could very well fall into the “pay a little now or pay a lot later” category that investors always want to avoid.

The decision behind the obligation depends on the type of option is at stake. A call option acts as a long position on a stock, in the sense that their buyers are looking for an asset to increase significantly before the option expiration date. A put option, on the other hand, acts similarly to a short position on a stock, in which their buyers are hoping the asset price will tumble before the option expiration date.

Why Are Options Attractive to Investors?

There are two significant reasons why investors turn to options as a solid investment strategy:

  • Speculation – With this strategy, the investor is essentially betting that there will be some positive movement on a stock or an asset. It’s where the profits are enormous, and the losses can be soul (and wallet) crushing. Successful options traders will correctly predict the stock’s movement, the price fluctuation, and a time frame in which it will happen. Needless to say, these factors don’t exactly translate to a sure thing, and those that aren’t prepared to do a lot of homework will almost always fail miserably.
  • Hedging – This strategy is almost the polar opposite of speculation. Rather than gunning for beaucoup bucks in a bull market, hedging acts as an insurance policy on your assets during a bear market. It’s a quite useful tool for those that want to jump into an asset or an industry that has tremendous upside without taking a bath if things don’t work out. For instance, it’s not too far-fetched to think that people that want to get involved with tech stocks may find a hedging strategy smart, due to that particular industry’s volatility.

An Example of an Option at Work

To demonstrate the nature of an option, let’s say it’s June 1st. You’re interested in a stock trading at $70. The option contract you assemble costs $3 a share for 100 shares, so you’re out of pocket $300. According to the agreement’s parameters, you’re expecting the price to be at or above $73 on the third Friday in August. When you factor in the contract cost, the stock needs to be trading at least at $76 on the expiration date to be profitable.

Let’s say the stock takes a nosedive and tanks, and it’s clear you’re not going to hit your mark. You don’t have to buy the stock, but you’re going to be on the hook for the $300, per the price of the contract. On the flip side, let’s say the stock surges up to $80. According to the options, the stock is up $700 ($7 per stock x 100 shares). Even when you subtract the $300 for the contract, you’ve made a tidy $400 on the stock.

When you extrapolate the examples in this formula to large numbers, it can be easy to see why it’s so attractive to individual investors. A word of caution, though The contract costs of unfulfilled contracts may add up quicker than you may think.

Are Options Right for You?

The effectiveness of options somewhat depends on your level of commitment. If you’re the kind of investor that doesn’t have the time and effort needed to make options work, then avoid it at all costs for the sake of your wallet.

However, if you have time to devote to deep analytics – and the enthusiasm required to derive enjoyment from diving into said analytics – then options trading may be something that may be right up your alley. There are obviously risks involved, and if you’re planning on entering the options game at a high level, this risks can be pretty monumental. But when you consider the upside that comes with this obligation-free method of trading, you may find the risks are well worth it compared to the reward.

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