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, betting that 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 in Operation
Options provide a source of leverage because they can be 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 $70 that expires in one months) costs $0.20 each. The premium is thus $2 per contract since each options contract is based on 100 shares of stock.
If the trader only buys stock, there will be simply a long position of 40 shares ($2,000/$50). But, if a position is taken using only options ($2,000/$2), they would effectively control a position of 1,000 shares. In this case, any gains and losses would be magnified by the leverage gained from using options. In this example, if the XYZ stock drops to $49 in six months, in the all-stock scenario, the trader's position is worth $1,960 (a loss of $40), whereas in the all-options situation, the total value would be $0 at expiration since the options would expire worthless because nobody would agree to buy shares at a price that is greater than the current market value.
The speculator's anticipation on the asset's future direction will determine what sort of options strategy that 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. In the event that the speculator's belief is correct and the asset's price does indeed go up substantially, they will be able to close out of the position and realize a 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, 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 in order to realize any applicable gains.