Purpose and Application of Options

When it comes to options, many people have a skeptical view, often influenced by the fear of the unknown. It’s not uncommon to hear phrases like, “Options are too risky for me” or “I wouldn’t touch options with a ten-foot pole.” Options, unfortunately, have earned an undeserved reputation as a financial minefield, when in reality, they can be valuable tools for savvy investors and traders when used thoughtfully and strategically. While options do indeed involve a level of risk, they can help achieve a variety of financial goals, including risk management, income generation, and even capital preservation.

In this blog, we’re going to provide you with a clearer, more balanced perspective about options by discussing various important purposes they can very well serve and their unique applications.

Let’s begin with a small introduction of options. If you already know, you can skip this para. They are derivative instruments that give the holder the right to buy or sell the underlying asset at a specific date and price. Like other derivative instruments, these instruments obtain value from the underlying asset. Trading options are immensely popular among investors and traders. Though options help traders to make a profit (speculate), investors also use them to reduce risk (hedge).

Primary Purpose of Using Options

Conceptually, there are mainly two purposes for using options. These are:

Speculation

In brief, speculation means betting on the price movement of volatile security in order to trade and earn profits in the short term. These professionals are called speculators. They are called professionals because they have good knowledge of the market they trade into. This differentiates them from Gamling.

Hedging

The use of options can serve as an insurance policy as well. Just like an insurance policy, options also help to cover the risks. Experts always recommend hedging the risk if you aren’t sure of the price movement. Thus, investors can use options to protect their investments from downside risk.

For example, Mr. A buys 100 shares of Company X at $30, expecting them to move up in three months. To hedge the risk, Mr. A buys a $1 per share put option that guarantees $25 per share.

Now, suppose that at the end of three months, the share price drops to $20. Mr. A’s loss in this case will be $6 ($30 +$1 – $25) per share. If there was no option, then the loss would be $10 per share.

To learn more, read our article Difference between Hedging and Speculation.

Other Purpose of Using Options

Broadly, options serve two purposes only – hedging and speculating. Traders or investors can use options for other purposes as well. These other purposes are not significantly different to the option’s primary purposes. They act more like different use-cases of options.

• Income Generation: Writing options can generate premiums and additional income from existing assets.
• Risk Management: Options are a tool to limit potential losses and define risk levels in a portfolio.
• Leverage: Options amplify potential gains or losses with a smaller upfront investment.
• Portfolio Diversification: Options provide exposure to diverse assets without owning them directly.
• Arbitrage Opportunities: Traders exploit price disparities between options and their underlying assets for risk-free profits.
• Income Enhancement: Options strategies like covered calls create extra income sources from assets.
• Tailoring Risk-Reward Profiles: Options help design strategies matching specific goals and risk tolerance.
• Volatility Trading: Traders profit from market volatility, irrespective of its direction.
• Synthetic Positions: Options mimic risk-return profiles of assets, offering flexible strategies.
• Capital Preservation: Lock in profits or set loss limits with options to preserve capital.
• Tax Management: Options can offset gains with losses for tax benefits.
• Diversified Trading Strategies: Options enable various trading strategies, each tailored to specific market conditions.
• Raising Capital: Companies use options, like employee stock options, as a form of compensation and capital raising.

It’s important to note that options can be complex and involve a level of risk, and it’s advisable to have a good understanding of options before using them for various purposes. Additionally, the suitability of an options strategy depends on an individual’s financial goals and risk tolerance, so it’s recommended to consult with a financial advisor or professional before engaging in options trading.

Participants in Options:

There are mainly four key participants in the market:

1. Option Buyer: The trader who purchases the right to exercise his option on the seller/writer by paying the premium.

2. Option Writer/Seller: The trader who gets the option premium. So, in case the buyer exercises the option, the seller must sell or purchase the asset.

3. Call Option: A call option gives its holder the choice, but not the obligation to purchase an asset at a predetermined price before a specific date.

4. Put Option: A put option gives its holder the choice, but not the obligation to sell the asset at a predetermined price before a specific date.

Frequently Asked Questions: