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In the modern investment world, there are likely to be derivative instruments that correspond with any given asset or security. From equities to commodities and interest rates to currencies, derivatives play an important role in helping market participants adjust their exposures. In essence, derivatives lock in the prices or rates of potential transactions and can be split between forward agreements, where the future transaction is fixed, and options, where future transactions are contingent.
The purchaser (or holder) of an option has the right, but not the obligation, to proceed with the future transaction. The seller (or writer/issuer) of an option must proceed with the future transaction if the holder wishes to proceed (exercise the option). This future transaction might be an option to buy (call option) or an option to sell (put option). The future transaction details are established when the option is first issued and includes the future date (maturity or exercise date) and future price/rate (strike or exercise price). For the ability to decide whether to exercise, the option holder pays the option seller an option premium.
For the price of the premium, a speculator can get a leveraged exposure to the underlying asset. Options can change in value at similar rate as the underlying, but can cost a fraction of the price. Thus, options can be an efficient way to gain a desired exposure. For the price of the premium, a hedger can get protection against adverse price movements of an asset already held. Furthermore, dealers and speculators that issue options can earn this premium.
Option investors are also often referred to as volatility traders; that is, many users of options look to earn a return based less on price direction expectations and more of price volatility expectations. The value of an option (i.e. the premium) increases as volatility (or price uncertainty) increases. This is due to the contingent nature of options and their exercisability, with greater volatility tending to lead to a higher probability that an option will move towards its strike price.
For most investors, the use of options is likely to be for the purpose of protecting wealth. This is commonly achieved through a 'protective put' strategy, whereby put options are purchased with a strike price that represents a maximum loss level. If the underlying investment falls in price, the net profit from the put option will help to reduce the loss. Unlike with a forward agreement, such an investor will still benefit if the underlying investment price were to increase. For specialist option investors, taking advantage of volatility expectations might be achieved through a 'straddle' strategy, whereby put and call options are purchased (for increasing volatility expectations) or sold (for decreasing volatility expectations).
Whilst the use of options to meet investment objectives has been common over the history of modern financial markets, they are instruments that still require a high-level of expertise to use appropriately. Their inherent leverage and contingent nature present conditions and risks that can be quite unfamiliar to the majority of investors and so should be used with care.
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