As a quick summary, options are financial derivatives that give their holders the right to buy or sell a specific asset by a specific time at a given price (strike price). There are two types of options: calls and puts. Call options refer to options that enable the option holder to buy an asset whereas put options enable the holder to sell an asset.

Speculation, by definition, requires a trader to take a position in a market, where he is anticipating whether the price of a security or asset will increase or decrease. Speculators try to profit big, and one way to do this is by using derivatives that use large amounts of leverage. This is where options come into play.

Options provide a source of leverage because they are quite a bit cheaper to purchase in comparison to the actual stock. This allows a trader to control a larger position in options, compared with owning the underlying stock. For example, suppose a trader has $2,000 to invest, and an XYZ stock costs $50 and an XYZ call option (with a strike price of $50 that expires in six months) costs $2 each. If the trader buys all stock, then he will have a position with 40 shares ($2,000/$50). But if he takes a position with all options, he effectively controls a position of 1,000 shares. In these cases, all gains and losses will be magnified by the usage of the options. In this example, if the XYZ stock drops to $49 in six months, in the all stock scenario, the trader's position is $1,960, whereas in the all option situation his total value will be $0. All the options would be worthless then, because no one would exercise the option to buy at a price that is greater than the current market value.

The speculator's anticipation on the asset's situation will determine what sort of options strategy that he or she will take. If the speculator believes that an asset will increase in value, he or she should purchase call options that have a strike price that is lower than the anticipated price level. In the event that the speculator's belief is correct and the asset's price does indeed go up substantially, the speculator will be able to close out his or her position and realize the gain (by selling the call option for the price that will be equal to the difference between the strike price and the market value). On the other hand, if the speculator believes that an asset will fall in value, he or she can purchase put options with a strike price that is higher than the anticipated price level. If the price of the asset does fall below the put option's strike price, the speculator can sell the put options for a price that is equal to the difference between the strike price and the market price in order to realize any applicable gains.

To learn more about options, see Options Basics Tutorial, Trading A Stock Versus Stock Options - Part One and The Four Advantages Of Options.

  1. Can mutual funds use leverage?

    Traditionally, mutual funds have not been considered leveraged financial products. However, a number of new products have ... Read Full Answer >>
  2. How do hedge funds use leverage?

    Hedge funds use several forms of leverage to chase large returns. They purchase securities on margin, meaning they leverage ... Read Full Answer >>
  3. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  4. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  5. Can mutual funds invest in options and futures?

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
Related Articles
  1. Credit & Loans

    Pre-Qualified Vs. Pre-Approved - What's The Difference?

    These terms may sound the same, but they mean very different things for homebuyers.
  2. Options & Futures

    Cyclical Versus Non-Cyclical Stocks

    Investing during an economic downturn simply means changing your focus. Discover the benefits of defensive stocks.
  3. Insurance

    Cashing in Your Life Insurance Policy

    Tough times call for desperate measures, but is raiding your life insurance policy even worth considering?
  4. Fundamental Analysis

    Using Decision Trees In Finance

    A decision tree provides a comprehensive framework to review the alternative scenarios and consequences a decision may lead to.
  5. Options & Futures

    Understanding The Escrow Process

    Learn the 10 steps that lead up to closing the deal on your new home and taking possession.
  6. Options & Futures

    Terrorism's Effects on Wall Street

    Terrorist activity tends to have a negative impact on the markets, but just how much? Find out how to take cover.
  7. Mutual Funds & ETFs

    Scared By ETF Risks? Try Hegding With ETF Options

    With more ETFs to trade, the risks associated with these investments have grown. To mitigate these risks, ETF options are a hedging strategy for traders.
  8. Mutual Funds & ETFs

    ETF Options Vs Index Options

    Investors have much to consider when they’re deciding between ETF and index options. Here's help in making the decision.
  9. Options & Futures

    How to use Straddle Strategies

    Discover how this sophisticated trading technique can unlock significant gains while reducing your losses.
  10. Options & Futures

    Top 4 Apps for Option Traders

    Discover some of the most popular apps that options traders use so they can stay on top of market opportunities and manage their investments.
  1. Crude Oil

    Crude oil is a naturally occurring, unrefined petroleum product ...
  2. Leg

    A leg is one component of a derivatives trading strategy, in ...
  3. Grant

    The issuance of an award, such as a stock option, to key employees ...
  4. Put-Call Parity

    A principle that defines the relationship between the price of ...
  5. Maturity

    The period of time for which a financial instrument remains outstanding. ...
  6. Employee Stock Option - ESO

    A stock option granted to specified employees of a company. ESOs ...

You May Also Like

Hot Definitions
  1. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  2. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  3. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
  4. Black Monday

    October 19, 1987, when the Dow Jones Industrial Average (DJIA) lost almost 22% in a single day. That event marked the beginning ...
  5. Monetary Policy

    Monetary policy is the actions of a central bank, currency board or other regulatory committee that determine the size and ...
  6. Indemnity

    Indemnity is compensation for damages or loss. Indemnity in the legal sense may also refer to an exemption from liability ...
Trading Center