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Stock, Futures Contracts, and Currency options are the most widely traded options in the financial markets. Each of these options types have one or more financial exchanges that actively trade them. Options are used by both speculators and hedgers alike. Speculators use them in an attempt to profit from an accurate prediction in either the change, or lack of change, of the underlying asset's price or price volatility. Hedgers use them to protect themselves from wild or unpredictable large price swings in the underlying asset's price.
It is very important when trading options to understand that price volatility can be just as important as the price of the underlying asset itself. An option is basically a bet in the future change, or if you're selling options the lack of change, in the price of the underlying asset. The price of an Option is set by the seller of the Option based on a formula like the Black-Scholes formula. The Black-Scholes formula calculates the Option's price using several factors. One of the most important factors is the recent volatility in the price of the underlying asset. The greater the volatility in the price of the underlying asset, the more expensive the price of the Option. Most inexperienced Options traders only think about the direction, up or down, of the underlying asset's price. To succeed with Options you must also closely watch the volatility of the underlying asset's price.
One of the most confusing aspects of understanding Options to the novice, is the difference between buying and selling Options. The difference between the strategies and tactics of a buyer and a seller of an Option are radically different.
The two basic kinds of options are Puts and Calls. Tactically, they have opposite goals with Put options being bought by investors who feel that the price of the optioned item will go down in the future, and Call options being bought by those who believe the price will go up. Conversely, sellers of these options believe the exact opposite will happen to the price, which is why they are willing to take the opposing side of what can be compared to a bet about the direction of the optioned item's price. (Note: Option sellers will also make money if the price of the optioned item doesn't change signicantly either).
Those who buy options are betting on two things, the direction of the price and that the speed of the change in price will accelerate. Since the current volatility of price is built into the cost of the option by the seller, the price of the optioned item must change faster than recently to earn the option buyer a profit. The seller of course hopes that the price goes the other way, stays flat, or doesn't move faster than the velocity of recent price movement. Price movement, or volatility, must be understood in depth to be a successful buyer or seller of options.
There is a second important reason to buy options, which is to use them to protect other investment assets. In this case, you do not buy them to make money off of them, but to protect assets you have against adverse price movements.
For example, you could own a 1000 shares of some company's stock, currently valued at $100 a share. You want to protect yourself against an upcoming quarterly earnings announcement that might hurt the stock's price. You could buy short term Put options at a strike price of $90 to cover your investment. Any movement of price below the $90 level would be covered by the Put option. Your total loss in this case would be $10 per share ($10,000) plus the cost of the Put option itself. If the quarterly earnings report was really bad and the stock shot down to $50 a share, this would be an immense help in protecting your portfolio. You could have bought options with a strike price at $100 (or any other price for that matter), but usually the cost of an option that close to the actual stock price would be too high to make it worthwhile. If you were short a stock and therefore trying to make money on the fall of that stock's price, you instead would by call options to protect yourself against a sharp rise in the stock price.
When options are used in this manner they are being used as insurance. When options are purchased to make money off price movements alone they are being used for speculation.
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