Monday, August 31, 2009

Options - what are they used for?

Options can be used for a number of purposes:

1. hedging: buyers or sellers of an underlying asset or holders of an underlying asset can buy or sell options to hedge their exposure to future fluctuations in the price of the underlying asset;

2. speculating: an investor can buy or sell an option as a means of speculating on the future direction of the underlying asset;

3. arbitrage: an investor can use options as a means of exploiting perceived current or anticipated future price discrepancies between underlying assets;

4. yield enhancement: the writing of options can be used as a tool for enhancing the yield on underlying assets.

The rule that there is no such thing as a free lunch applies to options as much as it does to all other forms of investment:

(i) if you write an option you receive a premium but have to post security and undertake to buy or sell the underlying asset at the agreed price if the buyer exercises the option. In simplistic terms, the writer is being paid a small but certain sum against the possibility of incurring a much larger loss;

(ii) if you buy an option you receive the right to buy or sell the underlying at your election but have to pay the option premium to the seller. In simplistic terms, the buyer of an option is paying a small but certain cost against the possibility of earning a much greater profit.

As mentioned in my previous post on option basics , the value of an option will depend upon (among other factors), the difference between the market price and the strike price, the volatility of the underlying, interest rates and the time left until expiry.

It is crucial to remember that an option has a finite life. When the expiry date arrives it must either be exercised or expire worthless. This means that (other things being equal) the value of an option will decay as the expiry date approaches. I am told (repeatedly) that the majority of options expire worthless.

There are a wide variety of strategies available to investors which involve options. As a relatively unsophisticated retail investor, I use only two:

1. yield enhancement: I write options as a means of enhancing yield on cash balances;

2. long or short equity speculation: I buy call or put options in anticipation of making speculative profits.

I will discuss each of these in future posts.

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