Before an investor runs out to purchase options, he needs to ask, "what do I expect these options to do for me? Will I be speculating on the future market prices hoping for large leverage, or will I be hedging my portfolio against a potential drop? Do I want a passive income on shares I already own, or do I merely want a guaranteed price to purchase shares at?"
There are many reasons to buy and sell options but you first need to analyze your motives for getting into options. As we go through the various ideals behind options trading, try to find the one that matches your particular trading style with associated risks and rewards.
Options Earn Income
The simplest way to earn income with option writing is by using the covered call strategy. This means that you own the underlying asset and write and sell an options contract for a premium. Below is such a scenario.
Scenario: You own 1,000 shares of Macquarie Group Limited (MQG). The market is fairly stagnant and your shares are trading sideways. You would like to make a little extra income from passively holding these shares.
You decide to write a one year long call option contract on these shares that have a strike price at the same value as the current price – or an ‘at the money’ option. The shares are trading for $46.71 so your portfolio is worth $46,710. You settle on writing a call option with a one year time value, and a strike price of $47. You receive $6.43 per share for this transaction, or $6,430 total. With this money you are able to re-invest or hold it for interest.
If the stock stays below $47 per share, the entire $6430 is yours to keep along with the 1,000 shares of MQG. If the share price rises above $47, you receive $47 per share (this is your strike price and it includes at 29 cent profit from the time since you wrote the option); you get to keep the $6,430, but you will need to forfeit your shares to the option holder. The most you can make on this is $6,720 (option premium plus $290 share price appreciation), which is a 14.4% increase.
The $6,430 profit from writing the call option is also a buffer to offset the loss of falling share prices. In this scenario, the price of MQG could fall to $40.28 by the end of the contract, and you would still be at a net break-even point.
This strategy can also be used for individuals bearish on the market that short stock and write put options on the position.
Options Protect Shares
Another broad strategy for options is to hedge or protect a portfolio. We will use the above example of owning 1,000 shares of MQG. If we are nervous about the potential for falling prices we can buy a put option contract that would hedge our portfolio share for share. All we need to decide upon is how much insurance or coverage we desire as determined by the strike price. This is the value that the insurance policy becomes active at and provides dollar for dollar payback against the declining share value.
It is important to remember that as the one value increases, the other decreases thus performing a hedging tactic.
Scenario: We are nervous about the next year of trading for MQG as the market is shaky. We still wish to hold the shares in case the stock swings upward. We also want uncapped profitability which we cannot get by writing call options on our stock. We decide to buy an ‘at the money’ put option with one year of time value. The share price is $46.71. Our strike price is at $46. This will cost us $6.11.
Imagine the share price drops to $40 after only 6 months. Our put option will be worth around $9.00 per share having $3 of extrinsic or time value and $6 of intrinsic value. Our total cost is $52.82 (share price of $46.71 plus put option contract of $6.11) and our remaining value after the panic drop is $49. We sustained a loss of $3.82 per share as opposed to $6.71 per share of the asset holder who did not use options. Even should the share price drop to zero, our put options contract will be worth $46 per share thereby losing a net of $6.82 instead of the total amount.
Options Provide Lower Risk Leverage
Buying on margin or purchasing a CFD provides leverage. But the uniqueness of options is that you can never lose more than what you pay for in premiums. If you think a stock will rise but only have $350 to invest, you can potentially make three or four times your investment from a modest price move, but never lose more than your $350.
With options you can gain dollar for dollar profit equal to the shareholder for a much lower cost and without having to own shares.
Time to Decide
Do you have a few good stories to tell of ‘almost could’ve been if….’? Most of us have tales of the stock we thought about buying but never did. With options you can purchase the right to trade a stock at a certain value, but have time to really decide if it is prudent to do so. Of course, time is money so you will need to pay for this right, but you will have more stories of stocks that made you big profits than the ones that got away.
Options Allow Index Trading
An index is a large basket of stocks merged together. The advantage of index trading is to spread individual company risk over many stocks. Trading index options is a great method for investors who like to analyze the broad market and trade long in bull markets and short in bear markets. Options provide a lower cost method of index trading.
The amount of other strategies that can be employed with options are too numerous to mention. But spread trading is one way that allows an individual to write and purchase options at the same time for reduced risk or for income generation. A good spread strategy analyst can make money in volatile or stagnant markets. Options are truly versatile for those wishing to delve into the endless combinations possible.