Why use options?

Why use options?

Why use options?

Why should the non professional investor use options?

There are two reasons for a layman investor might want to use options:

1) Lack of time to follow the markets closely

2) Desire for a non-linear profit and loss profile

Most private investors don't have time to follow the markets very closely. Most of us have jobs. Some have kids. There are plenty of other things a person might want to do instead of keeping a close eye on the market. If this is true for you should consider using an option. When you buy a put or a call the capital you risk is limited. You can't lose more than the premium you pay for the option. We are thus talking about long positions only. For long positions the complete opposite is true. You should never write options if you won't follow the market closely or have instructed your broker to close the position at a certain price. I.e. established a stop-loss. If you write an option the possible loss is very big. Theoretically infinite if you wrote a call option. So then you see why you can't write options is you are not willing or able to follow the markets very closely. More on the potential loss on commodity option here: http://commodity-option-trading.org/commodity-option-trading-4.html

The second reason to use an option is if you want a non-linear profit and loss profile. http://commodity-option-trading.org/commodity-option-trading-11-payoff-diagrams-bull-spread.html With that I mean that you don't want to be exposed to changes in the market price all the time. Only sometimes is the prices change very much. Let me illustrate with an example:

Say you run a small mechanical work shop. You have a few employees. Machinery like lathe, cutting tools and welding equipment. They use a lot of electricity. Normally you wouldn't worry about the electricity price. But you know that the electricity price sometimes shots up so much that it could move your operation from black numbers to red. Only happens once in a blue moon but you wouldn't want to have a whole working year result in a loss. So you need something that doesn't expose you to the electricity price during normal circumstances but makes you money in case the price shoots up a lot and you get big electricity bills to pay. Something like an insurance that you don't have to look after but will cover your electricity costs if they get too high. A call option could do this for you. Say the electricity price in your area is $10/kWh. Your electricity bill will start getting unpleasantly large at $20/kWh. If you buy a call option with a strike price of $20 it would start showing a profit when the electricity price goes above $20. So as your electricity bill grows, so does the profit on your call option. If you have done it correctly those two would cancel each other out. The loss on the electricity bill and the profit on the call option would cancel each other. That would let you focus on the things that you are good at. Engineering, manufacturing, talking to customers, having good relations with your employees. And let you sleep well at night knowing that any increases in the electricity price will be offset by your call option.

In case one you speculate. You think you have a good idea about where the price is going. You want to put your money where your mouth is but you are not able to follow the markets closely. In this case buying an option might be a good idea.

In case two you don't have any opinion where the market price is going. But you want to be insured against the market going bananas. Again, it might be a good idea for you to buy an option.

Do think twice before writing an option as the potential loss is big, possibly very big.

Samuel Winters

For a more in-depth look at options visit http://www.commodity-option-trading.org

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