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. Do options make more sense during bull or bear markets?

    Understand how options may be used in both bullish and bearish markets, and learn the basics of options pricing and certain ... Read Answer >>
  2. When is a put option considered to be "in the money"?

    Learn about put options, what they are, how these financial derivatives operate and when put options are considered to be ... Read Answer >>
  3. What is the difference between a banker's acceptance and a post-dated check?

    Learn more about speculation, stocks and options and how speculators use these financial instruments in an attempt to profit ... Read Answer >>
  4. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  5. When is a call option considered to be "in the money"?

    Learn about call options, their intrinsic values and why a call option is in the money when the underlying stock price is ... Read Answer >>
  6. What is the difference between "right" and "obligation" on a call option?

    Learn what a call option is, what determines a buyer and seller of an option, and what the difference between a right and ... Read Answer >>
Related Articles
  1. Trading

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  2. Trading

    Stock Options: What's Price Got To Do With It?

    A thorough understanding of risk is essential in options trading. So is knowing the factors that affect option price.
  3. Trading

    What's the Strike Price?

    The strike price is the price at which a derivative can be exercised, and refers to the price of the derivative’s underlying asset. In a call option, the strike price is the price at which the ...
  4. Trading

    Getting Started In Forex Options

    Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging.
  5. Trading

    What Is Option Moneyness?

    Get the basics under your cap before you get into the game.
  6. Trading

    The Basics of Options Profitability

    The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.
  1. In The Money

    1. For a call option, when the option's strike price is below ...
  2. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
  3. Out Of The Money - OTM

    A call option with a strike price that is higher than the market ...
  4. At The Money

    A situation where an option's strike price is identical to the ...
  5. Bear Call Spread

    A type of options strategy used when a decline in the price of ...
  6. Option

    A financial derivative that represents a contract sold by one ...
Hot Definitions
  1. Assets Under Management - AUM

    The market value of assets that an investment company manages on behalf of investors. Assets under management (AUM) is looked ...
  2. Subprime Auto Loan

    A type of auto loan approved for people with substandard credit scores or limited credit histories. There is no official ...
  3. Racketeering

    A fraudulent service built to serve a problem that wouldn't otherwise exist without the influence of the enterprise offering ...
  4. Federal Debt

    The total amount of money that the United States federal government owes to creditors. The government's creditors include ...
  5. Passive Management

    A style of management associated with mutual and exchange-traded funds (ETF) where a fund's portfolio mirrors a market index. ...
  6. Series 7

    A general securities registered representative license administered by the Financial Industry Regulatory Authority (FINRA) ...
Trading Center