Investors who only focus on buying and selling stocks miss out on a large segment of the investing world. Buying and selling options allow investors to protect themselves against losses and to make more money than just using stocks. In essence, call options allow investors to buy a stock at a certain price for a small premium and put options allow them to sell a stock for a certain price. Options have shaped the way investors trade stocks since they were designed.
Hedging
The main way investors use options are through hedging. In this case, options can act like insurance. An investor only pays a small amount to buy the option. If the underlying asset of the option doesn’t move like the investor intended, the value of the option increases, lowering the investor’s total loss to an acceptable level.
For example, an investor would buy 100 shares of ABC for $10.00 per stock. To hedge his trade, he would also by a put option for 100 shares, with a strike price of $10.00, for $2.50. If the price of ABC increases to $20.00, he would have made $1750 with hedging and $2000 without hedging (all transactions in this article will ignore transaction fees). If the price of the stock stays the same, he is only out $250, the cost of the option. If the stock loses half of its value, the option gives the seller the right to sell his shares at $10.00, thereby only losing the value of the option. Also, the value of the option increases, so it may be better for the investor to offset the loss by selling the option.
Increased Returns
Options can also let investors gain higher profits than they would have gained from just investing in stocks. Because options are cheaper than buying individual stocks, investors stand to make much more if they predict the correct move of the option’s stock. The downside is people who hold the stock still hold it even if they stock’s value doesn’t move in a certain direction, while option investors lose their entire investment if the stock doesn’t move as predicted.
Say the same investor again bought 100 shares of ABC at the same price above, but also bought 4 call options for ABC at the same strike price as above for the same cost. Both investments cost $1000. If the price of ABC either decreases or stays the same, the options go to zero but the stocks only lose part of their value. However, if ABC doubles in value again, the stock investment becomes $2000. Meanwhile, the option investment increases to $8000, before cost, if the options are exercised and the stock sold. The options allow investors to increase their gains in return for some additional risk.
Option Selling
Selling options has been compared to picking up nickels in front of a bulldozer. Options sellers make money off the fact that over 75% of options sold expire worthless. Option sellers issue options to buyers who pay them the premium, or cost, of the option. If they options isn’t exercised, the seller keeps the premium. However, if the option is exercised, the seller must provide the buyer with 100 shares for each option exercised. This can be very costly and wipe out the profits from many successful option trades. Most investors shouldn’t attempt option selling until they have a couple of years of experience in the field.
The diversity available in trading options gives investors and traders many different ways to profit from them. Great investors don’t only understand these ways to use options; they know how to use each method to achieve a high level of return. The key is to maximize the potential return while only increasing the risk by a smaller amount.