Unlike a future contract (sometimes referred to as a "future"), options allow a holder to buy or sell at a later date at his or her discretion. Most options are quite complicated and have the guidelines for the option written on what is called a term sheet. Term sheets usually specify such things as whether the holder has the right to sell, known as a "put" option, or the right to buy, which is known as a "call" option.
Though options do allow a holder a potential to gain a large amount of money, they have historically been very unpredictable. Options are often looked down upon in the investing world because so many investors have lost money on them. With the large potential for monetary gain comes an equally large risk for losing 100% or more of the money that was put into the option.
Unfortunately, the fact of the matter is that 80% if those that buy options actually end up losing money on them. The reasons for this can be summed up in three different factors: time, direction and magnitude.
As far as time is concerned, options are also known as a "time-wasting" asset. When you buy an option, you are basically racing the clock to see if you can make a profit before the option is completely worthless. As time goes on, the option loses value. As with all dealings in the financial market, time is very much essential in a holder's considerations. The holder has little, if any, way of knowing if it would be better to sell the option and break even, keep the option and have a 20% chance of gaining money or selling the option and getting rid of the risk permanently.
Another factor that affects the way options work is direction. The direction that the market could take in a short amount of time is very, very volatile. Buying and selling options is, once again, very much a gamble. If the holder guesses that the market will go up and it goes down, that holder will usually lose most, if not all, of their money.
In addition to these, there is one other factor that tells us why options are not the best idea for an investor. In addition to time and direction, the holder must also correctly guess that magnitude of the value of the option. The magnitude describes how big the increments will be of the value of the option rising or falling. Let us speculate that the holder correctly guesses that amount of time that it takes until the option is at its peak value and correctly guesses that the option is rising in value. If that holder does not take into consideration the increments in which that options value increased, that holder still loses money. Once the option expires, it has no time value left, and therefore the only value left in it is its intrinsic value, which is normally quite low. Therefore, the holder has once again lost money.
Therefore, options are much like gambling. A fortunate and shrewd few are able to beat the odds and make a good profit on dealing with options. However, it is, indeed, a gamble. Because 80% of those that deal with options lose more than they originally put into the option, that leaves them even worse off than before they bought the option.
With these statistics facing the purchase of an option, those that do so are taking a very large risk in doing so. While for the fortunate few it may have seemed worth the risk, the other 80% are left wondering why they took such a large risk.