Investment in the stock market always involves a lot of risks and is always capable of resulting in major financial losses. Many investors try to mitigate the risks by increasing their possible returns.
Options are probably the best instruments used for controlling the risk associated with investment. It allows hedging an investment, making speculation on a change in stocks, and maximizing the capital efficiency.
This article will delve into the basics of options, explaining what they are, why they exist, and how they can be used to protect investments or speculate on market movements. We will explore the two primary types of options – calls and puts – and illustrate their practical applications with real-world examples.
What is an Option?
An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell a particular asset at a specified price called the strike price on or before a specific date called the expiration date. Options are mostly used for hedging against potential losses or for speculation about the future movement of the market.
There are two main types of options:
Call Options: These give the holder the right to buy a stock at the strike price.
Put Options: These give the holder the right to sell a stock at the strike price.
Why Do Options Exist?
Options were invented to provide investors with more flexible ways of managing risks and optimizing returns. Options serve several purposes:
Hedging: Investors apply options to prevent their portfolios from unwanted market movements.
Speculation: Traders can make money from price movements without owning the underlying asset.
Leverage: Options enable investors to control a larger amount of stock with a smaller investment.
Types of Options
Call Options
A call option is a financial instrument that gives its holder the right but not the obligation to buy the shares of the stock at a predetermined price prior to or on a specific date. For instance, if a person buys a call option with the strike price set at $120, he/she can buy the stock at that price regardless of how high the market price of the stock is before the option is exercised.
Put Options
A put option is an option where the holder gets the right to sell shares of stock at a specified price before or on a certain date. If the stock price declines to $100 from the investor buying the put option for a strike price of $120, he still sells the stock at $120, hence saving his losses.
Real Life Application
Purchasing a Call Option
Assume you think that a certain stock, which is trading at $125, will go up in value over the next month. You can purchase a call option with a strike price of $125, which expires in 30 days. If the stock price goes up to $135, you can exercise your option to buy the stock at $125 and sell it at the market price of $135, making a profit on the difference.
Buying a Put Option
On the other hand, if you have a stock and you fear that it will decline in value, you could buy a put option. Suppose you have a stock that trades at $125, and you purchase a put option with a strike price of $120. If the market price of your stock declines to $100, you can sell your stock at $120 by exercising the put option. You will therefore minimize your loss.
Why Buy Options?
Insurance for Investments
Options buying is akin to taking a cover for your investments. In that case, if you buy 100 shares of a stock at $125 per share, your cost of investment will be $12,500. You can cover this by buying a put option. In the event that there will be a significant drop in stock price, the put option will allow the selling of the shares at the strike price to the disadvantage of actual losses.
Speculation with Limited Capital
Options also allow investors to speculate on stock price movements with less capital than would be required to buy the stock outright. By purchasing a call option, investors can gain exposure to potential price increases without the need to invest large sums upfront.
Factors Influencing Option Prices
Several factors determine the price of an option:
Underlying Stock Price: The current price of the stock affects the intrinsic value of the option.
Strike Price: The predetermined price at which the option may be exercised.
Time to Expiration: Options with a longer period to expire tend to have higher premiums because there is a greater likelihood that the stock price will run to the strike price.
Volatility: The higher the volatility, the more likely large price movements will be, which increases the premium of an option.
Real-Life Applications
Scenario 1: Stock Price Rises
Imagine you buy a call option for $500 on a stock trading at $125 per share. If the stock rises to $132, you can exercise your option to buy at $125 and sell at the market price, making a profit. Even after accounting for the $500 paid for the option, you still net a gain.
Scenario 2: Stock Price Decreases
If the price of the stock falls to $113, it means you could sell at a strike price of $125 while avoiding a significant loss. This is because in the absence of the put option, you would have sustained a loss of $1,200, while with the put option, the loss is $500, which was the premium you paid.
Options are a very potent financial instrument; they give investors much flexibility in managing risk while leveraging opportunities in the market. Whether used as a hedge in order to protect one’s investment or as a means of speculation to gain on potential opportunities, an understanding of how options work is of the utmost importance for any investor. Being able to understand and grasp calls, puts, and factors influencing price will allow an investor to make better-informed decisions that suit their choices in terms of finance.
