Options are a way to design investment strategies in detail for a relatively small amount of money. When using options exposure can both fluctuate – it only depends on the strategy used. Options may be used for investment/speculation and hedging.
Options are well suited for investment and speculation when the investor anticipates market movements. The desired investment may be achieved through limited means, and the potential loss may be narrowed down to the amount invested.
Advantages of options include allowing investors to:
gear their investments
speculate in price movements or hedge against price exposure in a simple and expedient way
go short in the market
make one investment that tracks the entire market through a single transaction only
Besides the element of speculation, options are eminently suited to hedging unwanted exposure. A purchase of call options may hedge against price risk for a shareholder that no longer wants the price exposure on his shares, but still wants any potential capital gain, which is why he sells his shares and buys call options.
Many of the strategies can be employed depending on the investor’s expectations to the movements in the market. The table below shows the strategies available in relation to the expectations to the market.
Market expectations and choice of strategy
Increase
Decline
Unchanged
Increasing volatility
Declining volatility
Buy call
X
X
Buy put Sell call Sell put
X X
X X
X X
Bull spread Bear spread
X
X
As can be seen from the table, the instruments can be used for all sorts of market movements, but also in relation to expected volatility changes. For other types of strategies that may include the underlying shares, the use of specific strategies is less unambiguous.
