Basics of Options (Derivatives) - Speculation and Hedging

Speculation is the betting on the movement of a stock (whether the stock goes up in value or goes down). The characteristic that differentiates options from other investment types is the ability to make a profit even if the stock goes down in value, or goes sideways. This is made possible by the sophisticated properties of Options.

When it comes to Options, Speculation is the name of the game. Speculation makes investors big money, and also loses them a lot of money. When buying options, you have to be successful in the following things in order to make a profit:

Correctly estimate the movement of the price of a stock (up or down)
Correctly determine by how much the price of a stock will go up or down
Amount of time it will take for the stock to go up (remember there will be a certain date upon which the Option expires and becomes worthless).
Amount of commissions you will have to pay to brokers as well as the cost of purchasing the Options

Hedging

Apart from speculation, investors buy Options because they can hedge. Hedging is more like buying an insurance policy on your house or your car. If you get into an accident while your car gets totalled, you want your insurance company to pay you a reimbursement right? In the same way, investors can limit their losses when purchasing Options and increase their chances of making profits by paying a price for hedging.
Note: Many Investors think that if you have to Hedge on a particular option, you should NOT be buying it anyways. This is because why would you want to buy an investment for which you think there's a chance of it losing substantial value?

Corporate Stock Options

Although Corporate Stock Options are NOT available to everyone, they are a third reason why investors buy Options. Corporate Stock Options are means of encouraging talented employees to stick with their Corporations for the longer term, especially the management. Stock Options allow employees to purchase their company's stock at a certain specified price within a specified period of time.