Managing Investment Risks: Options Strategies For Savvy Investors

Options are financial derivatives that give investors the right to buy or sell an underlying asset at an agreed-upon price and date. They are a versatile financial product that can be used for both speculation and hedging, with strategies ranging from simple to complex. While options trading can be risky, it can also be used to manage investment risks by reducing downside risk and providing leverage. Options allow investors to make directional bets with less potential loss than owning the outright stock position. Additionally, options can be used to hedge positions, with protective puts providing a price floor for investors. The options market was initially created to help institutional investors manage the risk of their long-term positions, and it can serve a similar function for individual investors.

Options can be used to hedge positions and reduce risk

A put option gives the holder the right to sell a stock, and the seller takes on the obligation to buy the stock. If the contract is assigned, the seller of a put option must buy the underlying asset at the strike price. Put options are commonly used by those holding long positions in an asset who feel the market is set for a correction. If the correction occurs, the holder profits; if prices continue to rise, their loss is limited to the premium paid on the options.

A call option gives the holder the right to buy the underlying asset, or the value of the underlying asset in the case of index options. The seller of a call option accepts the obligation to sell the stock (or the value of the underlying asset) at the agreed-upon strike price if assigned. Call options work in the opposite direction to put options. If the price goes higher than the exercise price of the call option, then a profit is made.

A protective put is an example of a hedging strategy that uses options to reduce risk. A protective put strategy involves buying a put option while also holding the underlying asset. This strategy is used as a form of insurance, providing a price floor for investors to hedge their positions.

Overall, options can be a valuable tool for investors to hedge their positions and reduce risk. By using put and call options, investors can protect themselves from potential losses and manage their investment risk more effectively.

Options can be used to minimise risk when making directional bets

Options can be used to reduce risk when making these directional bets. Options contracts can minimise risk through hedging strategies that increase in value when investments fall. Options can also be used to leverage directional plays with less potential loss than owning the outright stock position.

Long options can only lose a maximum of the premium paid for the option but have unlimited profit potential. This is because options are financial derivatives that give investors the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.

For example, a bullish investor who wishes to invest $1,000 in a company could potentially earn a far greater return by purchasing $1,000 worth of call options on that firm, as compared to buying $1,000 of that company's shares.

Options can also be used to minimise risk when making directional bets by structuring trades with greater flexibility than straight long/short trades in a stock or index. For instance, options can be used to make bets on the broader market or a particular stock, even if the anticipated movement in the underlying stock is not expected to be large.

There are four basic types of directional trading strategies that involve options:

• Bull calls: An optimistic play, when the investor thinks prices are rising. They create this by buying a call option with a lower strike price and selling a call option with a higher strike price.
• Bull puts: Also a bet that the markets are on an upswing. It's similar to bull calls but uses put options instead. Investors buy a put with a lower strike price and sell a put with a higher strike price.
• Bear calls: A pessimistic play, based on the belief that market prices will fall. Traders execute this by selling a call with a low strike price and buying a call with a high strike price.
• Bear puts: Another way to bet on declining prices. Traders create bear puts by selling a put with a low strike price and buying a put with a high strike price.

Options can be used to leverage directional plays with less potential loss than owning the stock

Options can be used to make directional bets, which refer to strategies based on an investor's view of the future direction of the market or a particular security. Directional investors take a long position if the market or security is rising, or a short position if the security's price is falling. Options offer greater flexibility for structuring directional trades compared to straight long/short trades in stocks or indexes. This is because options allow investors to make leveraged bets, where they can capture a larger position with the same amount of money.

For example, an investor with $10,000 can either buy 200 shares of a $50 stock or buy 10 options contracts of the same stock at $10 each, controlling 1,000 shares. In this case, the options trade has more risk than the stock trade as the entire investment can be lost if the stock drops to the strike price. However, the options trade also offers the potential for higher profits with less upfront capital.

Another benefit of options is that they can be used to hedge positions and reduce risk. For instance, a protective put option can be purchased as a sort of insurance, providing a price floor for investors to hedge their positions. Long options can only lose a maximum of the premium paid for the option but have unlimited profit potential. This makes options a useful tool for investors to manage their investment risk.

Options can be used to insure against the risk of markets crashing

Call options allow the holder to buy the asset at a stated price within a specific time frame. Put options, on the other hand, allow the holder to sell the asset at a stated price within a specific time frame. Call options are used when the investor expects the stock price to increase, while put options are used when the investor expects the stock price to decrease.

Options can be used to hedge or reduce the risk of an investment portfolio. They can be particularly useful for protecting against losses in volatile stocks. Index put options, for example, can provide insurance to investors during a bear market. These options will generate positive returns even as the assets in an investor's portfolio decrease in value.

Another way to use options to protect against market crashes is through portfolio insurance. This strategy involves short-selling stock index futures to offset any downturns in the market. This technique was developed by Hayne Leland and Mark Rubinstein in 1976 and is often associated with the 1987 stock market crash.

It is important to note that while options can provide protection against market crashes, they also carry risks. Investors should carefully weigh the risks and fully understand the potential implications before investing in options.

Options can be used to hedge downside risk

For example, suppose an investor buys a stock at $14 per share. They expect the price to go up, but if the stock value drops, they can pay a small fee (e.g., $7) to guarantee they can exercise the put option and sell the stock at $10 within one year. If, in six months, the value of the stock has increased to $16, the investor wouldn't exercise the put option, so they'll have lost the $7. However, if in six months the value of the stock fell to $8, they can sell the stock for $10 per share. With the put option, they would limit their losses to $4 per share.

The longer the time until expiration and the closer the strike price is to the current market price, the more protection and the higher the cost of the put option. A strike price closer to the present market price (at-the-money) protects more but is more expensive. Out-of-the-money puts (with strike prices below the current market price) are cheaper but only protect against more significant market declines.

A bear put spread is a cost-effective hedging strategy that provides limited protection. The investor buys a put with a higher strike price and sells one with a lower strike price with the same expiration date. This provides limited protection because the maximum payout is the difference between the two strike prices. However, this is often enough to handle a mild or moderate downturn.

A more complex variant is the ratio put spread, where the investor buys a certain number of put options at one strike price and simultaneously sells a higher number of puts at a lower strike price. This strategy can generate higher premiums and is often used in slightly bearish market conditions where a moderate decline is anticipated.

Long-term put options with low strike prices provide the best hedging value as their cost per market day can be very low. Although initially expensive, they are helpful for long-term investments.

Frequently asked questions