Options are a type of contract that provides an investor with the right to buy or sell a security at a specified price. An option contract doesn’t present an obligation for the investor to purchase or sell the security that the contract is written for. Options are described as derivatives because they are derived from an underlying asset, such as a stock or a commodity. There are many different types of options and option strategies, each offering their own unique sets of advantages and disadvantages for an investor.
Advantages of Options
Options can provide an investor with income, depending on the strategy used, or protect their securities from risk. Many investors use option contracts for speculation and make a profit when they speculate the direction of an asset correctly. Options contracts, when paired with the ownership of an underlying stock, can protect an investor’s stocks from a downward market, also known as a bear market. Protecting assets from negative effects are known as hedging.
Disadvantages of Options
There are a few inherent risks involved when trading options. Options are a speculative derivative, and by nature, this can present a risk for investors who are attempting to determine the direction that financial markets will travel. There are a variety of option trading strategies that investors can use to minimize the risks involved when trading options. However, many of these risk-preventing strategies also lower the profits that an investor can make when using the strategies.
Calls and Puts
Call options are options that give an investor the right to purchase a security at a specified price. A call option lasts until a predetermined date and does not need to be exercised by the buyer of the contract. If a call option is not exercised prior to its expiration date, then it will expire without any remaining value.
Put options provide investors with the opportunity to sell a security at a price that is specified in a contract. Put options work like call options and do not require an investor to exercise the option contracts prior to their expiration date. When a put option is exercised, an investor will sell their securities, and when a call option is exercised, an investor will purchase a group of securities.