Options
Why Use Options?
There are two main reasons why an investor
would use options: to speculate and to hedge.
Speculation
You can think of speculation as betting on the movement of
a security. The advantage of options is that you aren't limited
to making a profit only when the market goes up. Because of
the versatility of options, you can also make money when the
market goes down or even sideways.
Speculation is the territory in which the
big money is made--and lost. The use of options in this manner
is the reason options have the reputation of being risky.
Why? When you buy an option, you have to be correct in
determining not only the direction of the stock's movement,
but also the magnitude and the timing of this movement. To
succeed, you must correctly predict whether a stock will go
up or down, and you have to be right about how much the price
will change as well as the time frame it will take for all
this to happen. And don't forget commissions too!
So why do people speculate with options
if the odds seem so skewed? Aside from versatility, it's
all about using leverage. When you are controlling 100 shares
with one contract, it doesn't take much of a price movement
to generate substantial profits.
Hedging
The other function of options is hedging. Think of this as
an insurance policy. Just as you insure your house or car,
options can be used to insure your investments against a downturn.
Critics of options say that if you are so unsure of your stock
pick that you need a hedge, you shouldn't make the investment.
On the other hand, there is no doubt that hedging strategies
can be useful, especially for large institutions. Even the
individual investor can benefit. Imagine you wanted to take
advantage of technology stocks and their upside, but say you
also wanted to limit any losses. By using options, you would
cost-effectively be able to restrict your downside while enjoying
the full upside.
A Word on Stock Options
Although employee stock options aren't available to everyone,
this type of option could, in a way, be classified as a third
reason for using options. Many companies use stock options
as a way to attract and to keep talented employees, especially
management. They are similar to regular stock options in that
the holder has the right but not the obligation to purchase
company stock. The contract, however, is between the holder
and the company, whereas a normal option is a contract between
two parties that are completely unrelated to the company.
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