One of the great things about options is that you can use them for a very wide range of strategies, and each of these strategies has a different risk/reward profile. Some are high-risk, like the speculative buying of call and put options; others are designed to profit if specific future expectations are met.
People who are unfamiliar with options usually think about them only in this way, and overlook the potential for more conservative methods of (a) protecting portfolio positions, (b) spreading and hedging risk, and (c) generating additional income on your stock holdings. These strategies make options one of the more interesting ways to invest, and they are especially useful dealing with the challenges of volatile market conditions.
Non-Directional Strategies
One of the significant advantages of options is their flexibility. When you own stock, you make a profit only if one thing happens: the stock’s price moves above its current trading range. But options are so flexible that you can even make a profit if a stock stays within a limited trading range. Calendar spreads and short straddles are some of the strategies designed to produce profits if the stock price doesn’t move. This means an option position can be profitable even if the stock shows very little movement in the period of time you have the position open.
Other strategies are designed to create profits if the stock price moves in either direction, such as long straddles. In this case, you don’t really care what direction the stock price moves, as long as it does move. Because options can be used in so many combinations, their applications are rich. Once you understand how to use time as the key element in creating option profits, you will be well on your way to developing strategies that work for you.
Using Options for Insurance
Options can also be used to “insure” your position. For example, if you buy one put option for every 100 shares of stock you own, it gives you downside protection. As the stock price drops, the put goes up in value. And no matter how far the stock price drops, you have the right to sell your stock at the strike price specified by the put option.
You can also insure a short stock position. If you have sold stock short, the worst outcome would be a rising stock price. You can insure against that by buying one call option for every 100 shares you have sold short. As the stock price rises, the call goes up in value. And again, no matter how much the stock price rises, you have the right to buy the stock at the strike price specified by the call option.
You can use options to insure your portfolio as a whole. There are options available on many different stock indexes, including the Dow Jones Industrial Average, the S & P 500, and the NASDAQ 100. Buying puts on the index that is closest to the composition of your portfolio gives you protection from market risk. When the overall market drops, it is likely that most of the stocks in your portfolio will also drop in price. But the index puts will gain in value, offsetting much, if not all, of the drop in value of your stocks.
Generating Income from a Stock Portfolio
Covered writing is often touted as a safe way to generate extra income from a stock portfolio. It follows naturally from the simple purchase of stock, is relatively easy to explain, and results in immediate income. And it seems to be just as safe as simply investing in stock.
While speculative call buyers usually hold their position for a relatively short period of time, the covered call writer often expects to hold his position to expiration. The best part is that covered writers make money during periods when their stock holdings go nowhere. The income generated can be impressive, with annual returns of 20% or more, but you only get that kind of return if the stock goes up or remains around the same price.
It is especially important to remember that an option is a contract, with different rights and obligations for buyers and sellers. When you buy a call option, it means you have the right to buy 100 shares at the strike price specified. When you sell calls, the owner of that call option can impose the right on you. If the option buyer chooses to exercise his rights, you as the seller have the obligation to deliver the specified number of shares at the specified (strike) price. So you need to hedge a sold option in order to avoid that risk.
When you own 100 shares of stock and you sell a call on that stock, the strategy is not high-risk as it would be if you sold the call without owning the shares. In the event of exercise, you own the 100 shares and can simply deliver them to satisfy the contractual demands of the exercised call. A covered call writer is primarily seeking income. They also receive some downside protection (by the amount of the premium received), but the tradeoff is that the maximum possible profit is limited by the sold call. But this can be a worthwhile strategy as long as you pick your strike price carefully.
Conclusion
Options open up a lot of possibilities; opportunities for leveraged speculation, betting on specific market views, insurance, and income generation. So then why are options often considered to be riskier than stocks? The difference, of course, is time. Because options often expire worthless, you can easily lose all your investment.
Capital preservation can be every bit as important as capital appreciation to your long-term investment returns. Sure, every investor would prefer to have consistent gains all the time, but events outside your control can cause a temporary drop in the value in your investments. Make sure you always know the potential loss as well as the potential gain before you enter a trade, and be willing to accept the loss if it does occur. Experienced traders who are successful year in and year out will attest that risk management is the key to long term profitability, particularly limiting the potential loss for each trade to a certain (tolerable) percentage of your trading account.
Be sure to take your time when thinking about how to trade an option, and make sure you completely understand any strategy you use. Paper trading (without putting actual money at risk) is one way to begin gaining experience and learning how options behave. Once you master the concepts and strategies for options, you should do well when you begin to actually trade them.
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