Stock options received an incredibly bad rap in the wake of the 2008 banking crisis. Properly used, options can protect, grow and complement an investment portfolio in a number of ways depending on the needs of the investor. Here are just a few of the ways in which options bolster active trading.
#1 – As Insurance Against Loss
One of the simpler ways to use options is as an insurance against volatility in a stock. Many investors will buy calls or puts on stocks they already own in order to profit from any large movement of the stock. If an investor makes a purchase of an option in the opposite direction of a previous move that created profit, this is known as “hedging.”
For instance, Investor X owns 100 shares of XYZ stock that she bought at $10.00 per share. Stock XYZ goes up to $15.00 per share on October 15, and Investor X is uncertain that Stock XYZ will stay there. On the same day that the stock goes up, the investor purchases one XYZ put that expires in December at a strike price of $14.00. If the stock goes down to $14.00, the put gains value, protecting Investor X against the loss in the actual stock.
#2 – As an Income Strategy
Dividends are not the only way that a stock can provide a return on capital. Money placed into a stock is capital invested in that stock. One way to profit off of simply holding the stock is to sell covered calls or covered puts. These options give other investors the right to buy the stock at a certain price, which may or may not be advantageous to them depending on the movement of that stock in the future. Because of the nature of options to deteriorate over time (which can be measured by theta decay), many investors can actually create a month by month income strategy by selling covered calls and covered puts.
For example, Investor X now thinks that the 100 shares of XYZ that she owns at $14.00 will slowly go up in value, but the march will be slow and measured. Investor X can sell one covered call on her 100 shares that expires in one month at a strike price of $16.00, and does so at a total profit of $35. The month passes, and XYZ is only at $15.50. The investor who bought the covered call option that Investor X sold cannot profit from calling th shares away, and so the option expires worthless. Investor X has gained the $35 premium and gets to keep the 100 shares of XYZ, which are now open to have another covered call sold on them.
#3 – As a Limiter of Risk
A very effective risk management strategy that options can help an investor implement is known as “defining risk.” A defined risk means that an investor sets up a trade that has a maximum amount of loss – there can be no bigger loss than the one that is defined in the trade.
For instance, Investor X believes that XYZ will go up quite a bit in the next month, and she wants to buy a call option in order to take advantage of the research that seems to prove her hunch. She buys a call option for the stock at $16.00 that expires in November. However, she wants to limit the amount of loss she faces if her decision is wrong or something in the company changes course. Along with the call option for November at the $16.00 strike price, she also sells a call option at a strike price of $17.00 that expires on the same date. The maximum loss that the investor can suffer is the difference between the two prices multiplied by 100.
#4 – As an Indicator of Risk
Sometimes, an investor does not even have to trade an option in order to profit from it. One of the noted character traits of an option, its “implied volatility,” gives investors insights as to the future movement of the stock that it represents. The simplest way to use implied volatility is an an indicator of how volatile a stock is.
For instance, an option with a relatively low Vega suddenly has a much wider spread than before. This is usually an indication that the underlying stock is undergoing some big change in the future, and investors are unsure of whether the change will be positive or negative. Investor X takes this into account and sells XYZ in order to preserve her gains.