Options are basically a contract between two parties (one is writer, the other one is holder), where the holder (buyer, owner, take your pick) has the right to trade a financial instrument (a security, for example) at a predetermined price (strike price) and until a set date. Note that the holder does not have to do that, but is merely entitled to do so, should he or she chooses so. The writer, on the other hand, does have the obligation to act upon holder’s request and deliver the financial instrument in question, or to purchase it. The option to buy a financial instrument at a certain price is a “call”, and the option to sell a financial instrument at a certain price is called a “put”. If the agreed price is below the market value, the usual option is call, and if the market price is above, put option is typically implemented.

Pros

When it comes to versatility in the financial markets, few things can match options. They can be used as  anything from hedging tools aimed at risk management to various speculative purposes (which actually increase the risk), or anything in between. Nowadays, it is not uncommon for some companies to offer various stock options as incentives or even salary for their employees. Stock options can be sold to third parties, effectively conveying the rights to another holder.

Cons

Contrary to popular belief, stock options are not all sunshine and profits. For instance, holders can trade options but are not entitled to any income from actual companies, assets and financial instruments; likewise, they get absolutely no voting or executive rights other than call and put options. They get no say in anything else, even if that something might seriously affect the stock value. There are risks: counterparty, market, liquidity… Counterparty risk refers to the possibility that the other side does not deliver on the contract or defaults. Strong intermediaries can mitigate this risk even in volatile markets, but they are not all-powerful. Markets are nothing if not volatile and unpredictable; few traders can thrive in such chaos. And those that do, often find themselves unable to close deals because there is nobody on the other end who is willing to take the deal on the spot.

To conclude

The views on stock options can often vary, depending on whether you write or hold them. The writer basically hopes that value will fall soon after it is sold, as then he would be on top of things. The holder, on the other hand, bets that the value will rise, because then he can acquire it at a lower cost and net himself a nice profit by reselling it. Generally, it all depends on how you handle the stock options. They are a double-edged sword: they can make you rich, or ruin your finances just as easily.

This post is also available in: Croatian Serbian