Whether you’re hedging, seeking income, or speculating, you can put options to work for your portfolio.
Although options may not be appropriate for everyone, they’re among the most flexible of investment choices. Depending on the contract, options can protect or enhance the portfolios of many different kinds of investors in rising, falling, and neutral markets.
Reducing your risks with options
For many investors, options are useful as tools of risk management, acting as a way to protect your portfolio against a drop in stock prices. For example, if investor A is concerned that the price of his shares in XYZ Corporation is about to drop, he can purchase puts that give him the right to sell his stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option’s premium, investor A has protected himself against losses below the strike price. This type of option practice is also known as hedging.
While hedging with options may help you manage risk, it’s important to remember that all investments carry some risk, and returns are never guaranteed. Investors who use options to manage risk look for ways to limit a potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price for them. They can also profit from a rise in the value of the option’s premium, if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.
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Options for all investors
Investors with a conservative attitude can use options to hedge their portfolios, or provide some protection against possible drops in value. Options writing can also be used as a conservative strategy to bolster income. For example, say you would like to own 100 shares of XYZ Corporation now trading at $56, and are willing to pay $50 a share. You write an XYZ 50 put, and pocket the premium. If prices fall and the option is exercised, you’ll buy the shares at $50 each. If prices rise, your option will expire unexercised. If you still decide to buy XYZ shares, the higher cost will be offset by the premium you received.
Investors who anticipate a market downturn can purchase puts on stock to profit from falling prices or to protect portfolios—regardless of whether they hold the stock on which the put is purchased.
Rule of thumb
If you buy a call, you have a bullish outlook, and anticipate that the value of the underlying security will rise. If you buy a put you are bearish, and think the value of the underlying security will fall.
Investors can protect long-term unrealized gains in a stock by purchasing puts that give them the right to sell it at a price that’s acceptable to them on or before a particular date. For the cost of the premium, a minimum profit can be locked in. If the stock price rises, the option will expire worthless, but the cost of the premium may be offset by gains to the value of the stock.
Investors who anticipate a market upturn can purchase calls on stock to participate in gains in that stock’s price — at a fraction of the cost of owning that stock. Long calls can also be used to lock in a purchase price for a particular stock during a bull market, without taking on the risk of price decline that comes with stock ownership.
Investors with an aggressive outlook use options to leverage a position in the market when they believe they know the future direction of a stock. Options holders and writers can speculate on market movement without committing large amounts of capital. Since options offer leverage to investors, it’s possible to achieve a greater percentage return on a given rise or fall than one could through stock ownership. But this strategy can be a risky one, since losses may be larger, and since it is possible to lose the entire amount invested.
Profit with little investment
Options allow holders to benefit from movements in a stock’s price at a fraction of the cost of owning that stock. For example: Investors A and B think that stock in company XYZ, which is currently trading at $100, will rise in the next few months. Investor A spends $10,000 on the purchase of 100 shares.
But Investor B doesn’t have much money to invest. Instead of buying 100 shares of stock, she purchases one XYZ call option at a strike price of $115. The premium for the option is $2 a share, or $200 a contract, since each contract covers 100 shares. If the price of XYZ shares rises to $120, the value of her option might rise to $5 or higher, and Investor B can sell it for $500, making a $300 profit or a 150% return on her investment. Investor A, who bought 100 XYZ shares at $100, could make $2,000, but only realize a 20% return on her investment.
Most strategies that options investors use have limited risk but also limited profit potential. For this reason, options strategies are not get-rich-quick schemes. Transactions generally require less capital than equivalent stock transactions, and therefore return smaller dollar figures — but a potentially greater percentage of the investment — than equivalent stock transactions.
Even those investors who use options in speculative strategies, such as writing uncovered calls, don’t usually realize dramatic returns. The potential profit is limited to the premium received for the contract, and the potential loss is often unlimited. While leverage means the percentage returns can be significant, here, too, the amount of cash changing hands is smaller than with equivalent stock transactions.
What Are the Benefits Of Options Trading? by Inna Rosputnia
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