Table of Contents
Chapter 1: Introduction to Options Trading
Chapter 2: Options Trading Terminology
Chapter 3: Option Trading Strategies
Chapter 4: Types of Options Trading
Chapter 5: Common Applications of Options Trading
Chapter 6: How to Trade Options
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Chapter 5: Common Applications of Options Trading
– Hedging
– Speculation
– Employee Stock Options
Chapter 5: Common Applications of Options Trading
A good understanding of the markets, a sound investing strategy and the ability to judge the market are all necessary to make money with options trading. Even the simplest call and put options need some expertise on the part of the investor to generate good returns. These are highly speculative instruments and the risk of making significant losses is very high if you don’t know what you are doing.
In spite of these risks and complexities, options are still popular investment tools because they allow investors to use market movements to their advantage. One major advantage of an option is that you can not only make money when the market is going up but also when the market is in a rapid decline.
Here are some common applications of options:
In investing jargon, hedging means protecting your investment by making sure you limit your losses even if the investment fails. Options are used by many institutional investors to protect their positions if they find themselves on the wrong side of market movements. Individual investors can also use options in pretty much the same way so that they do not suffer huge losses if the market moves against their positions.
There are two schools of thought about using options to hedge your investments. Aggressive speculators believe that any way by which the stock market can be made to yield gains is a good way. The more conservative investors believe that hedging is simply betting on the failure of your investment. These investors state that it is far better to stay away from investments you believe are unsound rather than get involved in them and then resort to hedging to cover your bases.
Options are a great way to speculate on the future of a stock or even the overall market. A single option typically affects the price of 100 underlying shares and even a marginal change in the share price is multiplied a hundred times when you trade in options. This makes it easy to make substantial gains with a single decision, assuming it has been timed perfectly. Again, because the option lets the holder make money even when the markets are on a down turn, it is a way for the speculator to use even poorly performing stocks to his advantage.
A good speculator pays special attention to four aspects regarding the asset on which the option is based:
- In what direction will its value change in the neat future?
- By what amount will its value change?
- By when will the change occur?
- Will the change be large enough to cover option premium and brokerage commission?
Options are also used by employers as incentives to employees. Stock options which let employees purchase company stock at predetermined discounted prices are a popular way of rewarding employees. An employee who holds a stock option has the right to buy the shares of the company at a specific price within a time period.
A stock option gives the employee a stake in the company, which effectively links the success of his investment to that of the company. It is also a way to encourage loyalty among employees. With a stock option, it is the company which directly issues the option to the employee instead of the employee having to purchase it from an exchange or an option writer.
There are many other applications where options are used. Whether it is a standardized option or a customized one to suit individual investors, options are a great tool for successful investing when used with the right amount of skill and knowledge.
Next Chapter: How to Trade Options