The investing menu available to even the average investor is incredibly sophisticated. Even small retail investors have access to complex financial instruments, in addition to stocks and bonds. Derivatives, instruments that derive their price from the price of an underlying security, have grown to a staggeringly large market. Despite the negative perception of much of the investing public, derivatives have existed for a long time. In fact, one particular derivative, the futures contract, goes back to the time of the ancient Greeks. Futures contracts are used by farmers all over the world to hedge against the various risks that come with growing and selling crops.
Futures contracts are only one type of derivative. Options contracts, forwards contracts and swaps make up the other main categories. Traders and investors use derivatives to speculate and hedge against risk. There is only one risk in the investing world: Losing money on a trade or investment. Derivatives can be used in such a way as to offset the risk of lost money. Most investors use options to hedge their portfolios. Importantly, since options can be built around almost any underlying asset, they can be used to hedge almost any asset.
Options can be used to hedge stocks, bonds, real estate and other assets. Investors using options have a limited number of choices as to how they can be used. This is because the options market is set up with clearly defined rules that are really the consequences of the contracts themselves. An options contract has clear rights and responsibilities. Buying a contract gives the holder the right to purchase or sell a certain amount of an underlying security. For example, buying a stock option gives the holder the right to buy or sell a certain amount of stock shares at a given price.
The buyer pays a price to buy the option. This is known as the strike price. There are two kinds of options, calls and puts. A call option gives the buyer the right to purchase an asset, while a put gives the buyer the right to sell. These two kinds of options translate into four kinds of participants in the options market: call buyers, call sellers, put buyers and put sellers. Each has clearly defined roles due to the nature of the market and the contracts.
Sellers are obligated to make good on a promise to buy or sell an asset. Buyers, on the other hand, are not obligated to do anything. Whether they exercise their right to buy or sell an asset is entirely up to them. Alternatively, most investors and traders take their profits by reselling their contracts after they have gone up in value. Put options buyers are betting that the price of the underlying asset will fall, while call options buyers are betting that the price will go up. The value of a put or call option rises if the “bet” turns out to be correct. When the value of a contract rises above the strike price, the buyer of the option can exercise their right at a profit.
Options contracts have a time limit set by an expiration date. The buyer of the option must sell his contract or exercise the right to buy or sell the asset before the expiration date. Otherwise the buyer loses 100% of their investment because the contract becomes worthless. This introduces an additional element of time into the equation. The buyer of an option has a limited time to show a profit before incurring a loss. Options have their own risks even as they hedge against the risk of the underlying asset.
The versatility and contractual nature of options allows them to be used in myriad strategies. Some investors combine options with other derivatives like futures to execute complicated hedging strategies. The most basic method of using options to hedge is using calls and puts to take long and short positions in different assets. For example, an investor who believed the real estate market was going to decline could purchase puts that used an index like the Case-Shiller Home Price Index. A declining index means the put contracts rise in value, making a profit for the investor.
Aside from hedging and speculating, investors use options to boost their real returns. Options contracts allow investors to spend much less money and make the same profit they would have made anyway. Less money plus the same profit equals higher returns.
Another advantage of options is that they never stop trading. An investor who purchases a stock for a given price with a stop-loss order is only protected when the stock market is trading. When an unexpected event happens, such as unfavorable information about the company emerging when the market is closed, the price of the stock will open lower when the market opens the next day. The stop-loss order can do nothing; the investor has lost money even with the order in place. The options market never stops trading, because it is over-the-counter and not regulated on an exchange. The put option works for him all the time, even protecting him when the market is closed.