Options : Why use Options?
There are two main reasons why an investor would use options: to
speculate and to hedge.
Speculation - 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. Why? When
you buy an option, you have to be correct in determining not only the direction
of the stock's movement, but also the timing of this movement. To succeed, you
must correctly predict whether a stock will go up or down, and you have to be
right about 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 too! The combinations
of these factors means the odds are stacked against you.
You should know that majority
of the options expire worthless. So why do people speculate with options
if the odds are so skewed? Aside from versatility, it's all about using
leverage. Leverage is an investment technique in which you
use a small amount of your own money to make an investment of much
larger value. In that way, leverage gives you significant financial
power. For example, if you borrow 90% of the cost of a home, you are
using the leverage to buy a much more expensive property than you could
have afforded by paying cash. And if you sell the property for more than
you borrowed, the profit is entirely yours. So if you go back to our
example on the house, you risked $4,000 and made $16,000 in profit. Now
that's leverage and that's the kind of return you can get from options.
Hedging - 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. For
example, you might sell short one stock, expecting its price to drop. At
the same time, you might buy a call option on the same stock as
insurance against a large increase in value. 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 you wanted to take
advantage of Internet stocks and their upside, but say you also wanted
to limit any losses. By using options, you would cost-effectively be
able to restrict your downside while enjoying the full upside.
Next-->>
Different
types of options
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