Options and similar instruments such as warrants are risky but can play a useful part in a portfolio, whether you're using them to hedge, or to gear up your investment. Because so few investors seem to use them, I thought I'd put up the basics - and this article is very, very basic; if you already know about options, you can stop reading now.
Options and warrants are derivatives - that is, their value depends on the value of the share - so you'll need to have done your underlying analysis of the share's prospects before you start considering buying the options. One of the most attractive - but equally the most dangerous - aspects of options is that they can provide you with the ability to greatly leverage your money. With an options contract, you can - in effect - control a significant amount of stock with a relatively limited initial outlay (at least when compared to the cost involved with buying the stock outright).
Essentially an option is just what the name suggests - it is an option to buy or sell shares at a particular price, as if you said to a friend 'If you ever want to sell that car of yours, I'll give you five hundred quid for it.' Your friend doesn't have to sell you the car - but he can sell it to you at that price.
Yes, that's a childish example. But it's quite an important distinction between options and some other derivatives, such as futures, that you have the choice, and can let the option lapse. With futures, you don't have the choice - you have to exercise them. Traded options give you a third choice - as well as exercising the option (buying the shares), or letting it expire, you can trade it on the market. You can have a call or put option - a call gives you the right to buy the shares at a given price, a put gives you the right to sell them at that particular price. (In fact, very few traded options are ever exercised - that's not what they're there for.)
Traded options are available on LIFFE (the London International Financial Futures and Options Exchange), now part of NYSE Euronext. Be warned that a lot of regular online stockbrokers don't offer options trading, so you may need to find a specialised broker.
Traded…
