Portfolios today include investments that are mostly stocks, bonds and mutual funds. There are securities such as options that also offer investors a whole world of opportunity to expand their investment portfolios. Their power lies in their being versatile. They allow investors to adapt and adjust their position based on any situation that may arise in the financial market.
What is an option?
An option is a kind of a contract that will give a buyer the right to buy or sell a particular underlying asset at a specified price but it cannot be treated as an obligation on or before a specified date. As in the case of a bond or a stock, an option becomes a security.
Calls and Puts
The two kinds of options available are puts and calls. A put will give the holder a right to sell a particular asset at a specified price within a fixed period of time. A put is similar to maintaining a short position on a particular stock. A buyer of a put will hope that the price of that stock will go down before the option gets expired.
A call will give a holder the right to purchase an asset at a fixed price within a time period that is specified. A call is similar to maintaining a long position on a particular stock. A purchaser of a call will hope that the stock will go up considerably before the option gets expired.
There are four kinds of participants in the markets of options based on the position that is taken. They are buyers and sellers and pits and there are buyers and sellers of calls. Those who purchase options are known as holders and those who sell these options are known as writers. Buyers have long positions and sellers have short positions.
The price at which a particular underlying stock is bought or sold is known as the `strike price’. This is the price that a stock has to go above in the case of calls or go below in the case of puts before a position could be exercised for making profits. All this has to take place before the date of the expiry of options.
The option is supposed to be `in-the-money’ for call options if the share price is above this strike price. A put option will be `in-the-money’ if the share price goes below the strike price. The amount by which options are `in-the-money’ is generally known as their intrinsic value. The total price of an option is known as its premium. This price is established by factors that include the strike price, the stock price, volatility and the time that remains until the time value or expiration.
Reasons for investing in Options
There are two primary reasons why investors use options. They are speculation and hedging. Speculation could be treated as betting on the movement a security will take. The advantage of using options is that investors are not limited to making profits only when the market tends to go up. On account of their versatility, investors can also make profits when the market tends to go down or sideways. Success comes when investors are able to predict correctly whether a stock is likely to go up or down and they have to be correct about the change in pricing and also with the time frame it will take for all this to take place. Speculation also uses leverage.
Hedging could be thought of in the same way as you would look mat an insurance policy. Options are used to insure the investments against downturns much in the same way as you would insure your car or a house.