Although often overlooked as an investment avenue, options can provide some tantalising opportunities for the sophisticated trader. They are perhaps the most versatile investment type of all, and this flexibility means that there is money to be made on them irrespective of whether prices rise or fall. Positions can be adjusted continuously, offering numerous chances for the intelligent investor to adapt their stance so that it complements the immediate situation. Ideal for the libertine and the conservative alike, options might just make an ideal addition to your portfolio.
Read on to find out more…
What are Options?
The concept of options is actually rather simple to understand. In its most basic form, an option is no more than a contract. It provides the buyer with a right to purchase or sell the underlying asset at a specific price, on or before a certain date.
This might sound complicated, but it really isn’t. Imagine that you find a house that you’d like to buy. However, you won’t have enough money to purchase it until July. After a discussion with the owner, they reach an agreement with you stating that you’ll have the option to buy the house at any point up to the 15th July for £250,000. To seal the agreement, you pay them £5,000 up front for this option.
Imagine, too, that one month later it’s discovered that the house is the true birthplace of Elizabeth I. Its value soars to £1,000,000 as a result. Thanks to your option, the seller is still obliged to sell it to you for £250,000, provided the transaction takes place before 15th July.
Now consider this scenario instead: during a survey of the house, you discover that it’s full of asbestos. The option you bought gives you the opportunity to purchase the house for the agreed upon price, but it does not create an obligation. This means that if you now feel it’s worth less than this, you’re not obliged to buy it. Admittedly you’ll lose your £5,000, but you’ll have spared yourself a far greater loss further down the line.
Why Use Options?
There are two main purposes that options can be used for: hedging and speculating.
Speculating is where a trader bets on the movement of the underlying asset. This means that they can make money irrespective of whether the price of the security goes up or down. This is where the greatest profits can be made, but it also requires a degree of skill, as you have to be able to correctly identify the direction of the movement. Although this is a high-risk game, it remains very popular because even a small fluctuation can generate substantial profits.
Hedging is closer to an insurance policy, as it allows investors to protect their investments against any downturns. Many claim that if a hedge is necessary, then the investment should not be made at all, yet these strategies can still be very useful for large institutions.
If you’re considering your next investment move, could options be an ideal choice for you?