Why Use Options?
There are two main reasons why an investor would use options: to speculate and to hedge.
Speculation
You can think of speculation as betting on the movement of a security. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways.
Speculation is the territory in which the big money is made–and lost. The use of options in this manner is the reason options have the reputation of being risky. Why? When you buy an option, you have to be correct in determining not only the direction of the stock's movement, but also the magnitude and the timing of this movement. To succeed, you must correctly predict whether a stock will go up or down, and you have to be right about how much the price will change as well as the time frame it will take for all this to happen. And don't forget commissions too!
So why do people speculate with options if the odds seem so skewed? Aside from versatility, it's all about using leverage. When you are controlling 100 shares with one contract, it doesn't take much of a price movement to generate substantial profits.
Hedging
The other function of options is hedging. Think of this as an insurance policy. Just as you insure your house or car, options can be used to insure your investments against a downturn. Critics of options say that if you are so unsure of your stock pick that you need a hedge, you shouldn't make the investment. On the other hand, there is no doubt that hedging strategies can be useful, especially for large institutions. Even the individual investor can benefit. Imagine you wanted to take advantage of technology stocks and their upside, but say you also wanted to limit any losses. By using options, you would cost-effectively be able to restrict your downside while enjoying the full upside.
Generating income
Unlike buying options, when you need to strike the right balance of magnitude (target price) and timing, selling options lets you take advantage of the relative stability of the price of an underlying asset during certain periods.
For example, an investor who owns shares may decide to sell call options that, if exercised by the option owner, would require the shareholder to sell their shares at the selected strike price. This is known as a covered call option sale. The advantage of this type of strategy is that if the share stalls or its value is less than the strike price at expiration, the investor will earn a profit equal to the premium received when selling call options. This will generate additional income, which will boost the portfolio's return. Selling call options also provides some protection since any decline is offset by the premium received. Here's an example of a covered call option sale strategy.
Another way to generate income using options is by selling covered put options. The sale is covered in the sense that the investor has the capital needed to buy the underlying assets if the owner chooses to exercise the option. This will happen if the share price is lower than the strike price at expiration. Otherwise, if the share price is higher than the strike price at expiration, the option will have no value and the investor will earn a profit equal to the premium received, which will increase the portfolio return.
A Word on Stock Options
Although employee stock options aren't available to everyone, this type of option could, in a way, be classified as a third reason for using options. Many companies use stock options as a way to attract and to keep talented employees, especially management. They are similar to regular stock options in that the holder has the right but not the obligation to purchase company stock. The contract, however, is between the holder and the company, whereas a normal option is a contract between two parties that are completely unrelated to the company.