When to use options


There are a number of scenarios where traders can use options.

Hedging

Hedging sounds complicated, but it is simply a way insuring oneself against certain risks in the market.

For example, if you wanted to protect yourself from a sudden decline in the price of the stock you hold, you could buy put options in the very same stock with a strike price that is at or above the price you paid for the stock itself. That way, you are guaranteed the right to sell the stock at the price stipulated in the put option contract. If the price of the stock they are hedging does not decline, the worst-case scenario is that that you will let the option expire worthless – in other words, let the expiry date come and go without taking any action. All this “insurance” has cost you is the original premium you paid to the writer of the put option.

However, if the stock in question does decline dramatically in price, you can exercise the put option. This means that the contract writer will be forced to buy shares of stock from you at the strike price. You are thereby protecting yourself from a significant loss when the stock price declines.

Speculation

If you want to speculate on a stock that you think will likely increase in share price, you can buy a call option on that stock. Since a call option gives you the right to buy the stock from the call option writer at the strike price, by selecting an option contract with a strike price well below the price you believe the stock will eventually reach, you could end up being able to buy the stock from the call option writer at a significant discount if the stock rises as anticipated.

On the other hand, if you think a stock is likely to decline in price, you could speculate on it by doing the opposite. By buying a put option that has a strike price at or above the current price of the stock, you have gained the right to sell it to the writer at a price that is much higher than the price you think the stock will reach. If the stock fails to decline, then you only have to let the option expire, and you have only lost the premium you paid for it.

So why would someone write an option on a stock if they could be obligated to be on the losing end of a trade? The answer is quite simple: the writer of an option collects a premium for every put or call contract that is sold. If the writer sells a put option on a stock, he or she believes that the stock is going to appreciate in price.

If that does happen, then the buyer of the put option will choose not to exercise it. In the meantime, the writer has collected a premium from the put option, and has therefore earned some income.