Term Paper: First Draft: Approval

Pages: 15 (4720 words)  ·  Style: MLA  ·  Bibliography Sources: 3  ·  Level: College Senior  ·  Topic: Economics  ·  Buy This Paper

¶ … Contracts: An Examination

Nearly everyone who is even vaguely familiar with the stock market is familiar with the expression, "buy low and sell high." However, the issue with that method is that it is only effective in one kind of market -- bull markets. Options are a means of expanding one's trading strategy and allowing there to be a higher amount of profit from market patterns. Options allow one the possibility to profit regardless of the direction that stocks take: they have the ability to help one to cut losses, protect one's gains and to control a more massive amount of the stock market with a smaller amount of cash at the outlay. Thus, options can offer versatility, but with a certain amount of risk. The key to minimizing one's risk really revolves around the ability to truly understand all the nuances connected with options so that one's understanding is completely rock solid.

Options Defined: What are Options?

An options contract refers to an agreement which is made between a buyer and seller which allows the person buying the option the strict right to buy or sell a specific asset at a later date for a price which is specific and agreed upon. Such contracts are often used in securities, commodities or business dealings. Essentially, options are forms of contracts where the seller gives the buyer the opportunity, but not the obligation, to purchase or sell a specific number of shares at a set price within a set time period.

"Options are derivatives, which means their value is derived from the value of an underlying investment. Most frequently the underlying investment on which an option is based is the equity shares in a publicly listed company. Other underlying investments on which options can be based include stock indexes, Exchange Traded Funds (ETFs), government securities, foreign currencies or commodities like agricultural or industrial products" (Nasdaq.com). Options are also traded on securities marketplaces among institutional investors, individual investors, and professional traders for single contracts or for numerous ones. The following elements can help in defining an options contract: type, security, unity of trade, strike price and expiration date (nasdaq.com).

Why Use Options

One major reason to purchase options is to hedge. Put options can ultimately pay off and be a truly effective form of insurance for one's overall portfolio: "And in true supply demand fashion, when optimism reigns, the price of put option insurance goes down (insurance is cheapest when no one wants it)" (Fischer, 2010). Using options to hedge means that you have a means of hedging against any potential decline. Furthermore, as an additional bonus, when the market turns contrary, one can sell the puts back into the market for profit when insurance is all of a sudden in a higher demand, offering stock to potentially bounce back. "On a more granular level, you can also use a strategy called a collar to protect individual stocks that you own during uncertain times. Worried that Dell's upcoming earnings announcement will be poorly received? Sell a call option for every 100 shares owned, with a strike price a buck or two higher than the current share price, and then use the proceeds to buy a put a buck or two below the current stock price -- with both options expiring after the expected earnings date, you can set up your protective collar for little or no cost" (Fischer, 2010). In such an example, one is protected against the stock price plummeting beneath the put strike price, but this level of defense does arrive at the price of giving up the benefits in the stock price beyond the call strike.

Another means of using options is to speculate. One can think of using options in this manner as a means of placing a bet on the direction a movement of a security is going to make (investopedia, 2014). This offers a distinct benefit in that one thus isn't limited to generating a profit only when the market rises. This means that as a result of the versatility of options, one isn't bound to making a profit only when the market rises. The versatility of options means that one can also make money when the market plummets or even moves sideways.

Speculation refers to the territory where one can acquire intense profits or lose such massive profits. "The use of options in this manner is the reason options have the reputation of being risky. This is because 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" (investopedia, 2014). Thus all of these components, in conjunction with the commissions involved, mean that using options in this manner is a rather high risk venture. Even so, options offer versatility and leverage when controlling profits and shares.

Types of Options

Several types of options contracts generally abound in financial transactions; for instance, an exchange traded option is settled via a clearing house and has a guarantee attached to it (IA, 2014). These types of options encapsulate stock options, commodity options, bond and interest rate options, index options and other such rewards (IA, 2014). Yet another variety of option contract is the over-the-counter option which is traded between two parties in a manner which includes interest ration options, currency exchange rate options and means of swapping so that either long or short-term interest rates are received (IA, 2014).

American vs. European Options

One of the major differences between American vs. European Options is that the former can be used whenever; on the other hand, a European options can be used only at its specific expiration date. Thus, American options offer an enhanced level of flexibility and potential. "Thus, we can say American Options = European Options + Premium where the Premium is greater than or equal to zero" (Harvard.edu).

Calls and Puts

Standard options actually only come with two specific varieties: call options and put options. Many experts agree that having a basic understanding of the differences between these two options is essential before getting started. "For each call contract you buy, you have the right (but not the obligation) to purchase 100 shares of a specific security at a specific price within a specific time frame. A good way to remember this is: You have the right to 'call' stock away from somebody" (Tradeking, 2014). Likewise, for every contract bought, one has the right, but not the obligation to sell 100 shares of a specific security, at a set price within a set time frame: thus, one has the right to "put" stock to someone. In this sense, one also needs to bear in mind that commissions also apply, with their cost being factored into the decision process.

Long-Term Options

If used wisely, investing in long-term options can have a real pay-off: "The potential loss of 100% of capital invested also means that they should only be used in the rare circumstances where the upside potential is significant" (investopedia, 2014). Thus, this highlights both the potential for loss and for gain when it comes to investing in options: though the risk is at times significant, the reward is as well.

Exotic Options

Exotic options refer to non-standardized options with specific conditions placed upon them so that they are better able to help the individual investor with issues which are generally traded over the counter (Jason, 2014). In a similar fashion, exotic options contain two broader categories: standardized and non-standardized. Standardized options often get the term "plain-vanilla options" a generally typical when it comes to the options traded over stock exchanges. Non-standardized options are the ones which come with special standards and conditions, making them more ideal for specific investor needs (Jason, 2014).

How Options Work

"The main features of an exchange traded option, such as a call options contract, provides a right to buy 100 shares of a security at a given price by a set date. The options contract charges a market-based fee (called a premium). The stock price listed in the contract is called the "strike price. At the same time, a put options contract gives the buyer of the contract the right to sell the stock at a strike price by a specified date. In both cases, if the buyer of the options contract does not act by the designated date, the option expires" (IA, 2014). Thus, a basic call options contract might mean that a trader anticipates that the ABC Company's stock will go up to $100 in the next month. In this manner, the trader is able to see that he can purchase an options contract of this company at $5.00 with a strike price of $70 per… [END OF PREVIEW]

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