Options are financial derivatives that give their holders the right to buy or sell a specific asset at a specific time at a given price (strike price). There are two types of options: calls and puts.
Long call options are options that enable the option holder to buy an asset at a pre-determined price. Long put options enable the holder to sell an asset at a pre-determined price. Conversely, options traders holding short positions must sell an asset at a pre-determined price for a call and are required to buy an asset at a pre-determined price for a put.
Speculation is the position a trader takes in the market betting that the price of a security or asset will increase or decrease. Speculators seek large profits and often use options, or derivatives, that provide sufficient leverage.
Options in Operation
Options provide a source of leverage because they can be cheaper to purchase in comparison to buying 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. A share of XYZ stock costs $50 and an XYZ call option (with a strike price of $60 that expires in one month) costs $0.20 per share. The premium for one contract, then, would be $20, since each options contract is based on 100 shares of stock.
If the trader chooses only to buy stock, there will be a long position of 40 shares ($2,000/$50). However, by using options, the trader could control 10,000 shares with the same $2,000 investment ($2,000/$0.20), hence, the power of leverage.
In this case, gains and losses are magnified by the leverage gained from using options. If the XYZ stock rises to $70 in one month ($10 over the $60 options strike price), in the all-stock scenario, the trader's position is worth $2,800 (a gain of $800). In the all-options situation, the total gain would be $100,000 (10,000 shares x $10). Conversely, if XYZ closed above $50, but below $60, the stock-only transaction would still show a profit, however, the options-only transaction would produce a $2,000 loss, demonstrating the cost of options contracts.
The speculator's anticipation of the asset's future direction will determine which options strategy is taken. If the speculator believes that an asset will increase in value, they should purchase call options that have a strike price that is lower than the anticipated or targeted price level. If the speculator is correct and the asset's price increases substantially, they will be able to close out of the position and realize a gain. The gain would be equal to the difference between the strike price and the market value, plus any remaining time value remaining on the option.
If the speculator believes that an asset will decrease in value, they would instead 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, plus any remaining time value, to realize a gain.
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