A financial option (or financial derivative) is a contract between two parties by which one party, called option holder or party in the long position, has the right, but not the obligation, to buy/sell a specified asset, called the underlying asset, at a specified amount of money, called exercise value, at a specified time, called expiration date, from/to the other party. If the holder decides to exercise his/her right, then the other party, called option writer or party in short position has the obligation to buy/sell the asset. The options which give the holder the right to buy are called call options, and the options which give the holder the right to sell are called put options. Option trading is the act of engaging in trade of securities, particularly in the options market.
The Power of the options are directly related to versatility of them. Choosing the proper time to buy an option, the time which one selects to exercise them, and the combination of different option which one chooses to maximize the pay off ( for example options selections to build an optimize portfolio) are the points that should be focused on if one likes to trade options.
Different kinds of options have different characteristics , however the common property among all of them is that they give the holder the power to adopt or adjust himself/herself against specific stochastic or unwanted market fluctuations, or in another words they enable the holder to hedge his/her underlying asset against the risk. Uncertainty due to lack of complete information leads to stochastic behaviour of the financial markets, which is the source of risk. The right possessed by the holder has some value, and the holder should pay for this value called option premium, to enter a option contract. So options are not risk free properties. Options are Complex and Complicated securities, so they are definitely risky, and that is the main reason that options trading are very important and also full of risk. On the other hand if one wants to invest on something or if he/she decides to build a portfolio of different stocks, assets, etc. he/she has to use options not to be placed in weak position. Options also enable the holder to speculate, means they equipped the holder to calculate the pay off with more certainty and to bet on the movements of the underlying securities, this property is one of the critical options properties. If one has the proper options then he/she may make some benefits even if the market goes down or sideways, in another meaning one could say options are multidirectional, the holder of the option can yield profit without being influenced by market direction. Also we can add this point that managing the options is not really time consuming and complicated in compare of the stocks and assets, so most of the people can easily come up with options trading, briefly, options are easy, for example options can be traded at the end of the day without having to sit at your computer for hours at a time, and this is another important reason for trading in options. An option is also a good add-on, as an illustration suppose one decides to hold a stock for a long time, then writing an option would be an excellent strategy to add value to his/her investment. Another main reason of trading the options around the world is that they are affordable, trading the options are a good strategy to invest on stocks or any underlying assets without paying too much money. Options are also good for short term investment, while some bonds or stocks or other securities are long-term investments over the period of many years, option can pay off in a shorter time like days, or few weeks, this enables the investors to see the results much sooner in options that are not available in other securities. This quality of the options is a suitable one which matches with this fast-paced world. Furthermore options are flexible, in compare with stocks, options offer different packages depend on different exercise prices and expiry dates, which gives the holder the opportunity to work with these properties in a more innovative way. Another amazing reason for trading options is that they are leverage, for example, when one buys an option in fact he/she buys the power to control several shares of the assets with less money.
Speculating and hedging are two major reasons for using options. We first start with speculations and speculators . In speculations process one may lose or make lots of money. In the other words speculation is the area in which a serious risk is executed. When one buys an option he/she should be able to predict the underlying price movements and also should know about the time and the quantity of that movement, or he/she will face a great loss. This short definition of speculation can illustrate the importance of speculators role in options trading, obviously the holders of options will be charged by this speculators or investment advisors or brokers to get advice for buying or selling specific options or more general securities. Speculators are sophisticated and risk-taking investors with expertise in the markets in which they are trading and will usually use highly leveraged investments such as options to increase the potential return of an investment. Most of the work which speculators are doing is about applying leverage (margin buying allows use of leverage), they use the various combinations of financial instruments to modify or optimize the pay off. Leverage may enable the speculator to operate easier and better, however it is highly risky, because it can maximize both gains and losses. Speculators play a useful role in an efficient market (which its prices take into account all knowledge that people have about that market) where prices adjust rapidly to new information.
Moreover, options are really good instruments for hedging, they are really practical to reduce the risk of adverse price movement in an asset, so we can consider options trading as an insurance policy for underlying assets. So hedgers are some advisors who know how to manage the risk and not to lose much money in the markets based on the frequency of events, magnitude or severity of events, available information, confidence in available information, available knowledge and experience. Obviously, again the investors have to pay some commissions to the hedger to get their advices.
Here we are going to focus on the difference between speculating and hedging more precisely. In hedging strategies we are trying to insure ourselves against stochastic factors which cause serious unpredictable changes to the asset price, nevertheless in speculation, the main goal is understanding the direction of the asset price movement, and so get benefits from some kind of betting on the movement of the asset price.
One of the most common ways for hedgers to decrease the potential risk is to take the position which is opposite of the target asset that they are going to hedge, this way they will be protected from any harsh losses, and equivalently they will be limited from any big profits. On the other hand successful speculators, who can guess the direction of the asset price correctly, mostly gain profit from short selling, if the underlying goes down in price, and surely sometimes if it goes up. So it seems that hedgers are always looking for the ways to get rid of the risk, conversely speculators are trying to expose themselves to risk.
In addition to hedgers and speculators there are another major players in financial markets called arbitrageurs. Arbitrage is making risk free profit using borrowed money or short selling, it is clear that arbitrage opportunities can not be found in practice for ordinary people, since if there had been such opportunities then it would have vanished very soon based on a very simple argument about market equilibrium. However in reality arbitrageurs have the ability to find these impossible chances and profit from price differential existing in two markets by operating in those markets simultaneously, as a consequence of this, the price in different markets will be converged rapidly in order to cancel this opportunity. In options market, arbitrage trades are usually executed by firm or floor traders. They hope to gain some small risk free profits. Speculators are different from arbitrageurs, although the speculators activities will be something that the arbitrageurs take into account. Anyway an speculator is not a middle man (who tries to achieve the minimum risk), nor is he/she an entrepreneur (who deals with a very risky searches for new economic niches, opportunities to make a profit).
