We’ve all heard of options. They may seem overwhelming to think about, but options are easy to understand if you know a few key points. Investor portfolios are usually constructed with several asset classes. These may be stocks, bonds, ETFs, and even mutual funds. Options are another asset class, and when used correctly, they offer many advantages that trading stocks and ETFs alone cannot.
Options are powerful because they can enhance an individual’s portfolio. They do this through added income, protection, and even leverage. Depending on the situation, there is usually an option scenario appropriate for an investor’s goal. A popular example would be using options as an effective hedge against a declining stock market to limit downside losses. Options can also be used to generate recurring income. Additionally, they are often used for speculative purposes such as wagering on the direction of a stock.
The best way to think about options is this:
“Options give you options.”
There is no free lunch with stocks and bonds. Options are no different. Options trading involves certain risks that the investor must be aware of before making a trade. This is why, when trading options with a broker, you usually see a disclaimer similar to the following:
Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.
Options belong to the larger group of securities known as derivatives. This word is often associated with excessive risk-taking and having the ability to bring down economies. Even Warren Buffett has referred to derivatives as “weapons of mass destruction.” That perception, however, is really overblown.
All “derivative” means is that its price is dependent on, or derived from the price of something else. Think of it this way: wine is a derivative of grapes; ketchup is a derivative of tomatoes; a stock option is a derivative of a stock.
Options are derivatives of financial securities – their value depends on the price of some other asset. That is essentially what the term, derivative, means. There are many different types of securities that fall under the label of derivative, including calls, puts, futures, forwards, swaps (of which there are many types), and mortgage-backed securities, among many others. In the 2008 crisis, mortgage-backed securities and a particular type of swap caused all the trouble. Options were largely blameless. (See also: 10 Options Strategies To Know.)
If you know how options work, and how to use them appropriately, you can have a real advantage in the market. Most importantly, options can allow you to put the odds in your favor. If using options for speculation doesn't fit your style, no problem – you can use options without speculating. Even if you decide never to use options, it is still important to understand how companies you invest in use them. For instance, they might hedge foreign-exchange risk, or give employees potential stock ownership in the form of stock options. Most multi-national corporations today use options in some form or another.
This tutorial will introduce you to the fundamentals of stock options. The concepts can be broadly applied to assets other than stocks, too. Many options traders have years of experience, so don't expect to be an expert immediately after reading this tutorial. If you aren't familiar with how the stock market works, you might want to check out the Stock Basics tutorial first.
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