You have heard about options and, initially, you may find it an overwhelming concept. But if you take a little time to understand options, they are really an uncomplicated asset class. Options, as the term indicates, provide you with a variety of options. Used correctly and effectively, options offer you numerous advantages vis-à-vis other asset classes such as stocks, bonds, ETFs, and mutual funds. Options provide you protection since you can benefit from the upside in a rising market while you can hedge your risks in a declining market and limit the losses.
Options – participating in the future price change
An option is a contract to buy or sell an asset at a pre-negotiated price. Options trading is a simple process and it gives investors the potential to participate in a future price change. Essentially, it means that investors can determine the price of an asset today based on what they think the price would be in future taking into account events that could impact the price of that asset. For instance, investors can observe the calendar of events of a company and make a decision to invest in the stock options of that company’s shares based on a launch of a new product, process or technology etc. Options belong to a large group of securities known as derivatives. The word derivative means that the price of the asset is derived from the price of something else. Just as wine is a derivative of grapes, a stock option is a derivative of a stock. Options are derivatives of financial securities and their value depends on the price of the asset from which they are derived. For instance, the stock options of Apple would derive their value based on the price of Apple stock. Just as you buy shares of a company because you think the price will go up or sell your holding in a company if you think the price is going to fall, an option allows you to play on either direction. However, in the case of options, you don’t have to buy or short an asset outright. Instead, you enter into a contract that allows you to do many things such as buying or selling the asset at an agreed-upon price for a limited period of time, sell the contract to another investor, or allow the contract to expire so that the investor does away with any further financial obligation.
Options are versatile since they give investors the flexibility to speculate across asset classes – stocks, forex, commodities, and indices. For investors who like to wager on the economy and want to benefit from rising and falling markets, investing in an entire index may be a more attractive proposition rather than picking individual stock options. Options allow investors to take a top-down approach and speculate on the entire market rather than focusing on individual stocks. Such investors can take advantage of market-impacting events such as rise or fall in interest rates, employment numbers, or inflation. Options have become an intrinsic part of business practices and companies use options to hedge their risks against foreign exchange or rise in commodity prices. Options are rapidly emerging as a major part of the investment strategy of institutional and retail investors.