A:

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 in Operation

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. (See also: Options Basics Tutorial, Trading A Stock Versus Stock Options—Part One and The Four Advantages Of Options.)

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