There are two main reasons why an investor would use options: to speculate and to hedge.
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. This is because 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 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! The combinations of these factors means the odds are stacked against you.
So why do people speculate with options if the odds are 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.
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 that you wanted to take advantage of technology stocks and their upside, but you also wanted to limit any losses. By using options, you would be able to restrict your downside while enjoying the full upside in a cost-effective way.
Hedging is often considered an advanced investing strategy, but the principles of hedging are fairly simple. Read on for a basic grasp of how this strategy works and how it is used. (For more advanced coverage of this subject, read out How Companies Use Derivatives To Hedge Risk.)
Most people have, whether they know it or not, engaged in hedging. For example, when you take out insurance to minimize the risk that an injury will erase your income or you buy life insurance to support your family in the case of your death, this is a hedge.
You pay money in monthly sums for the coverage provided by an insurance company. Although the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.
Hedging by the Book
Hedging, in the Wall Street sense of the word, is best illustrated by example. Imagine that you want to invest in the budding industry of bungee cord manufacturing. You know of a company called Plummet that is revolutionizing the materials and designs to make cords that are twice as good as its nearest competitor, Drop, so you think that Plummet's share value will rise over the next month.
Unfortunately, the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile. This is called industry risk. Despite this, you believe in this company - you just want to find a way to reduce the industry risk. In this case, you are going to hedge by going long on Plummet while shorting its competitor, Drop. The value of the shares involved will be $1,000 for each company.
If the industry as a whole goes up, you make a profit on Plummet, but lose on Drop – hopefully for a modest overall gain. If the industry takes a hit, for example if someone dies bungee jumping, you lose money on Plummet but make money on Drop.
Basically, your overall profit (the profit from going long on Plummet) is minimized in favor of less industry risk. This is sometimes called a pairs trade and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk. (To learn more, read the Short Selling tutorial and When To Short A Stock.)
Hedging has grown to encompass all areas of finance and business. For example, a corporation may choose to build a factory in another country that it exports its product to in order to hedge against currency risk. An investor can hedge his or her long position with put options or a short seller can hedge a position though call options. Futures contracts and other derivatives can be hedged with synthetic instruments.
Basically, every investment has some form of a hedge. Besides protecting an investor from various types of risk, it is believed that hedging makes the market run more efficiently.
One clear example of this is when an investor purchases put options on a stock to minimize downside risk. Suppose that an investor has 100 shares in a company and that the company's stock has made a strong move from $25 to $50 over the last year. The investor still likes the stock and its prospects looking forward but is concerned about the correction that could accompany such a strong move.
Instead of selling the shares, the investor can buy a single put option, which gives him or her the right to sell 100 shares of the company at the exercise price before the expiry date. If the investor buys the put option with an exercise price of $50 and an expiry day three months in the future, he or she will be able to guarantee a sale price of $50 no matter what happens to the stock over the next three months. The investor simply pays the option premium, which essentially provides some insurance from downside risk. (To learn more, read Prices Plunging? Buy A Put!)
Hedging, whether in your portfolio, your business or anywhere else, is about decreasing or transferring risk. It is a valid strategy that can help protect your portfolio, home and business from uncertainty. As with any risk/reward tradeoff, hedging results in lower returns than if you "bet the farm" on a volatile investment, but it lowers the risk of losing your shirt. (For related reading, see Practical And Affordable Hedging Strategies and Hedging With ETFs: A Cost-Effective Alternative.)