The Ins and Outs Of How Options Trading Works

Options are purchasing the "option" to buy or sell a security if it reaches a goal price at a certain time. For example, say I want to buy (and this would never happen, it's just easier to think about when you aren't talking securities and are talking objects we buy daily) tomatoes. I want 40 tomatoes, but not at $1.50 each. I want them in 30 days, so if in 30 days, those tomatoes go below $1.20 each, I will buy 40 tomatoes. If not, well then I don't have to buy. I only purchased an option to buy those. If the price goes up or not down far enough, I can walk away and only pay for the option and not the 40 tomatoes. 

This works for selling too. Options are like buying insurance. They are good to have in a bad (or rare) situation, but not that great to have in a normal market situation. It is like predicting what will happen. 

This is the biggest reason why someone would want to buy or sell an option. Say I want to purchase a straddle. I am predicting that this stock will move a lot, however I'm not sure if the price will go up a lot or down a lot. So I basically buy 2 options (a call and a put) so that there is the strike price of $50 (that is the price I'll buy the stock at, no matter how it moves). I will then place my call and put around that, so a buy will happen if the stock goes way up, and the sell happens if the stock goes way down. Now if a large jump happens, I can now go back and say to myself "Looky there....I have an option to buy at this low price of $50 and now the stock is up to $90!" and therefore I make a profit. However, I'm also paying A Lot to have an option, so that comes out of my earnings.

Now if the stock price doesn't move at all, then I am stuck paying for that expensive option and I never got to use it. It is a way to make money, or to hedge (protect) yourself against a problem. It however, costs a lot to do.

Businesses might use the "hedge" option (like the straddle I mentioned earlier) if they are going to be buying or selling a lot from a foreign country and are worried that the exchange rate will become more expensive for them. We personally wouldn't want to do that; however, a company who buys and sells millions of dollars worth of stuff, would want this protection.

Investors have the ability to hedge against foreign currency risk by purchasing a currency option put or call. For example, assume that an investor believes that the USD/EUR rate is going to increase from 0.60 to 0.95 (meaning that it will become more expensive for a European investor to buy U.S dollars). In this case, the investor would want to buy a call option on USD/EUR so that he or she could stand to gain from an increase in the exchange rate.