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Why options strategies belong in every trader's toolbox
Koen Hoorelbeke
Investment and Options Strategist
Why options strategies belong in every trader's toolbox.
In the world of investing, diversification is a term that is often thrown around. It's about spreading your investments across various asset classes to mitigate risk. But diversification isn't just about investing in different types of stocks or bonds; it's also about using different financial instruments. One such instrument that every investor should consider is options. Some call them the Swiss army knives of finance, and not without reason.Options are contracts that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. They can be used in a variety of ways to enhance an investment portfolio. Below is a list with 5 common use-case scenario's that illustrate this. For each use-case I included a practical example.
1. Income Generation: One of the most common uses of options in an investment portfolio is for income generation. By selling options, investors can earn premium income in exchange for their obligation to buy or sell the underlying asset. This strategy, known as writing covered calls and/or selling cash-secured puts, can provide a steady stream of income in addition to any dividends or interest the portfolio might generate.
2. Hedging: Options can also be used to protect a portfolio from downside risk. By purchasing put options, investors can hedge their portfolio against a potential drop in the market. This acts as an insurance policy, limiting the potential losses from a market downturn.
3. Leverage: Options allow investors to control a large amount of an underlying asset with a relatively small investment. This leverage can amplify returns, although it can also increase risk.
4. Flexibility: Options offer the flexibility to profit from various market conditions. Whether you're bullish, bearish, or neutral on the market or a specific stock, there's an options strategy that can work for you.
5. Cost Efficiency: Options can be less expensive than buying the underlying asset outright. For example, buying a call option requires less capital than buying shares of the underlying stock.
In conclusion, options are a versatile tool that can enhance an investor's portfolio. They provide opportunities for income generation, risk mitigation, and increased flexibility. However, like all investment strategies, they come with their own set of risks and should be used judiciously. It's important for investors to understand how options work and to use them as part of a well-balanced and diversified portfolio.
Let's elaborate on each use-case by looking at an example:
1. Income Generation
Imagine you own 1000 shares of The Coca-Cola Company (KO:xnys), which is currently trading at around $60 per share. You like the long-term prospects of the Coca Cola and plan to hold the shares for several years. However, you'd like to generate some additional income on your investment. To do so, you could write a covered call on your shares. After doing some research, you decide that you'd sell a call option with a strike price of $62.5 that expires in 45 days. For selling this option, you will receive a premium of 0.40 USD, or $400 total (since one options contract represents 100 shares, and you have 1000 shares, equaling to 10 contracts).
There are two possible outcomes at the expiration of the option:
- If Coca Cola's stock price stays below $62.5 (our chosen strike price), the option will expire worthless. You keep the $400 premium as income, and still own the 1000 shares of Coca Cola. You can now choose to sell another call option to generate more income. This would result in a profit of 0.6% return on capital (400 premium / 60000 share-value * 100). If you would do this 8 times a year, you would generate +5% (8 * 0.666%) extra income on your investment, over the course of a year. (in this example there are 45 days till expiry, hence the frequency of 8, but you can actually choose to do it on a weekly or monthly basis).
- If Coca Cola's stock price rises above $62.5, the option will likely be exercised. You will have to sell your 1000 shares of Coca Cola for $62.5 each. However, you still keep the $400 premium. In this case, your total income from the trade is the premium plus the $2.5 per share appreciation of your stock, for a total of $2900 (400 + 2.5*1000).
In both scenarios, you generate income from the premium received from selling the option. This strategy can be repeated weekly, monthly or quarterly, providing a steady stream of income in addition to any dividends the stock might pay.
Please note that while selling covered calls can generate income, it also caps the potential upside of the stock. If Coca Cola's stock price were to rise significantly, you would miss out on any gains above the $62.5 strike price. As always, it's important for investors to understand the trade-offs involved in any investment strategy.
There are two possible outcomes at the expiration of the option:
- If Coca Cola's stock price stays below $62.5 (our chosen strike price), the option will expire worthless. You keep the $400 premium as income, and still own the 1000 shares of Coca Cola. You can now choose to sell another call option to generate more income. This would result in a profit of 0.6% return on capital (400 premium / 60000 share-value * 100). If you would do this 8 times a year, you would generate +5% (8 * 0.666%) extra income on your investment, over the course of a year. (in this example there are 45 days till expiry, hence the frequency of 8, but you can actually choose to do it on a weekly or monthly basis).
- If Coca Cola's stock price rises above $62.5, the option will likely be exercised. You will have to sell your 1000 shares of Coca Cola for $62.5 each. However, you still keep the $400 premium. In this case, your total income from the trade is the premium plus the $2.5 per share appreciation of your stock, for a total of $2900 (400 + 2.5*1000).
In both scenarios, you generate income from the premium received from selling the option. This strategy can be repeated weekly, monthly or quarterly, providing a steady stream of income in addition to any dividends the stock might pay.
Please note that while selling covered calls can generate income, it also caps the potential upside of the stock. If Coca Cola's stock price were to rise significantly, you would miss out on any gains above the $62.5 strike price. As always, it's important for investors to understand the trade-offs involved in any investment strategy.
2. Hedging
Consider that you own 100 shares of Tesla Inc. (TSLA), which is currently trading just below $280 per share. You've made a good profit on the shares as you originally bought them for $200 (just an example). However, you're concerned about a potential downturn in the market over the next few months and you want to protect your gains. To hedge/shield against a potential drop in TSLA's stock price, you could buy a put option. Let's say you decide to buy a put option with a strike price of $260 that expires on October 20, 2023. This put option gives you the right to sell your TSLA shares for $260 each, regardless of how low the stock price might fall. The cost (premium) of this put option is $20.85 per share, or $2,085 total.
There are two possible outcomes at the expiration of the option:
- If TSLA's stock price stays above $260, the put option will expire worthless. You lose the $2,085 premium paid for the put option, but your TSLA shares are still worth more than the strike price of the put. The premium can be considered as the cost of insurance against a price drop.
- If TSLA's stock price falls below $260, the put option will come into play. You can exercise your right to sell the shares for $260 each, regardless of the current market price. This limits your loss on the shares and helps protect your investment.
In both scenarios, the put option serves as a form of insurance, protecting you from a significant drop in the stock price. This is the essence of hedging with options.
In the above example we use a simple PUT-option to illustrate the principle of performing a hedge using options. There are more efficient ways to do this, using options. Please visit Protecting a long stock market position from turbulence for a comprehensive explanation and example on how to do that with a more advanced and cost-effective options-strategy.
There are two possible outcomes at the expiration of the option:
- If TSLA's stock price stays above $260, the put option will expire worthless. You lose the $2,085 premium paid for the put option, but your TSLA shares are still worth more than the strike price of the put. The premium can be considered as the cost of insurance against a price drop.
- If TSLA's stock price falls below $260, the put option will come into play. You can exercise your right to sell the shares for $260 each, regardless of the current market price. This limits your loss on the shares and helps protect your investment.
In both scenarios, the put option serves as a form of insurance, protecting you from a significant drop in the stock price. This is the essence of hedging with options.
In the above example we use a simple PUT-option to illustrate the principle of performing a hedge using options. There are more efficient ways to do this, using options. Please visit Protecting a long stock market position from turbulence for a comprehensive explanation and example on how to do that with a more advanced and cost-effective options-strategy.
3. Leverage
Imagine you're bullish on MongoDB Inc. (MDB), which is currently trading at $410 per share. You believe the stock will rise in the next few months, but buying 100 shares would cost you $41,000 - a significant investment. Instead of buying the shares, you could leverage your investment using a call option. Let's say you decide to buy a call option with a strike price of $360 that expires on November 17, 2023. This call option gives you the right to buy MDB shares for $360 each, regardless of how high the stock price might rise. The cost (premium) of this call option is $85.45 per share, or $8,545 total.
There are two possible outcomes at the expiration of the option:
- If MDB's stock price stays below $360, the call option will expire worthless. You lose the $8,545 premium paid for the call option. This is your maximum possible loss, which is significantly less than the $41,000 you would have risked if you bought the shares outright.
- If MDB's stock price rises above $360, the call option will come into play. You can exercise your right to buy the shares for $360 each, regardless of the current market price. If, for example, MDB's stock price rises to $480, your profit would be $120 per share minus the $85.45 premium, or $3,455 total. This is a 40.4% return on your investment, significantly higher than the 17% return you would have made by buying the shares outright.
In both scenarios, the call option provides leverage, allowing you to potentially make a higher return with a smaller investment. This is the power of leverage with options.
Please note that while buying call options can provide leverage and potentially higher returns, it also involves higher risk. If the stock price doesn't rise above the strike price, the entire premium is lost. As always, it's important for you to understand the trade-offs involved in any investment strategy.
There are two possible outcomes at the expiration of the option:
- If MDB's stock price stays below $360, the call option will expire worthless. You lose the $8,545 premium paid for the call option. This is your maximum possible loss, which is significantly less than the $41,000 you would have risked if you bought the shares outright.
- If MDB's stock price rises above $360, the call option will come into play. You can exercise your right to buy the shares for $360 each, regardless of the current market price. If, for example, MDB's stock price rises to $480, your profit would be $120 per share minus the $85.45 premium, or $3,455 total. This is a 40.4% return on your investment, significantly higher than the 17% return you would have made by buying the shares outright.
In both scenarios, the call option provides leverage, allowing you to potentially make a higher return with a smaller investment. This is the power of leverage with options.
Please note that while buying call options can provide leverage and potentially higher returns, it also involves higher risk. If the stock price doesn't rise above the strike price, the entire premium is lost. As always, it's important for you to understand the trade-offs involved in any investment strategy.
4. Flexibility
Let's consider Activision Blizzard Inc. (ATVI), which is currently trading at $83 per share. The company is in the middle of a potential takeover by Microsoft, but the outcome is uncertain due to regulatory issues. This uncertainty could lead to a significant price move in either direction. In this situation, you could use a Long Straddle strategy, which involves buying a call and a put option with the same strike price and expiration date. This strategy profits if the stock makes a big move in either direction.
Let's say you decide to buy a call and a put option with a strike price of $82.5 that expire on November 17, 2023. The call option costs $6.88 per share, and the put option costs $4.73 per share, for a total cost of $11.61 per share, or $1,161 total.
There are two possible outcomes at the expiration of the options:
- If ATVI's stock price stays close to $82.5, both options will expire worthless, and you lose the $1,161 premium paid for the options. This is your maximum possible loss.
- If ATVI's stock price makes a big move in either direction, one of the options will come into play. For example, if ATVI's stock price falls to $62.5 due to the failed takeover, your profit from the put option would be the difference between the strike price and the stock price, minus the total premium.
In this case, the profit would be ($82.5 - $62.5) * 100 - $1,161 = $839. This represents a return of approximately 72% on your initial investment of $1,161.
The long straddle provides flexibility, allowing you to profit from a big move in either direction. This is the power of flexibility with options.
Please note that while long straddles can provide flexibility and potentially higher returns, they also involve higher risk. If the stock price doesn't make a big move in either direction, the entire premium is lost. As always, it's important for you to understand the trade-offs involved in any investment strategy.
Let's say you decide to buy a call and a put option with a strike price of $82.5 that expire on November 17, 2023. The call option costs $6.88 per share, and the put option costs $4.73 per share, for a total cost of $11.61 per share, or $1,161 total.
There are two possible outcomes at the expiration of the options:
- If ATVI's stock price stays close to $82.5, both options will expire worthless, and you lose the $1,161 premium paid for the options. This is your maximum possible loss.
- If ATVI's stock price makes a big move in either direction, one of the options will come into play. For example, if ATVI's stock price falls to $62.5 due to the failed takeover, your profit from the put option would be the difference between the strike price and the stock price, minus the total premium.
In this case, the profit would be ($82.5 - $62.5) * 100 - $1,161 = $839. This represents a return of approximately 72% on your initial investment of $1,161.
The long straddle provides flexibility, allowing you to profit from a big move in either direction. This is the power of flexibility with options.
Please note that while long straddles can provide flexibility and potentially higher returns, they also involve higher risk. If the stock price doesn't make a big move in either direction, the entire premium is lost. As always, it's important for you to understand the trade-offs involved in any investment strategy.
5. Cost Efficiency
Apple is a well-established company with a strong track record of performance. As of July 3, 2023, Apple's stock is trading at around $192. Let's say you believe that Apple's stock price will increase over the next few months, but you don't want to invest a large amount of capital to buy the stock outright. Instead, you decide to purchase a call option.
You find a call option for Apple with a strike price of $200, expiring on November 17, 2023. The cost of this option is $7.70 per share. Since each option contract represents 100 shares, the total cost of this option contract is $770.
Now, let's consider two scenarios:
- Apple's stock price increases to $230 by the option's expiration date. In this case, you can exercise your option to buy 100 shares of Apple at the $200 strike price, costing you $20,000. You could then sell these shares at the current market price of $230 per share, making $23,000. After subtracting the $770 you paid for the option, your net profit would be $2,230.
- Apple's stock price decreases to $190 by the option's expiration date. In this case, it wouldn't make sense to exercise your option to buy shares at $200 each when you could buy them on the open market for $190. So, you let the option expire worthless. Your loss in this scenario is limited to the $770 you paid for the option.
In both scenarios, the cost of the option is significantly less than the cost of buying 100 shares of Apple outright. This is a clear demonstration of how options can provide cost efficiency in your investment strategy.
You find a call option for Apple with a strike price of $200, expiring on November 17, 2023. The cost of this option is $7.70 per share. Since each option contract represents 100 shares, the total cost of this option contract is $770.
Now, let's consider two scenarios:
- Apple's stock price increases to $230 by the option's expiration date. In this case, you can exercise your option to buy 100 shares of Apple at the $200 strike price, costing you $20,000. You could then sell these shares at the current market price of $230 per share, making $23,000. After subtracting the $770 you paid for the option, your net profit would be $2,230.
- Apple's stock price decreases to $190 by the option's expiration date. In this case, it wouldn't make sense to exercise your option to buy shares at $200 each when you could buy them on the open market for $190. So, you let the option expire worthless. Your loss in this scenario is limited to the $770 you paid for the option.
In both scenarios, the cost of the option is significantly less than the cost of buying 100 shares of Apple outright. This is a clear demonstration of how options can provide cost efficiency in your investment strategy.
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