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"I've always been confused about options trading...
at least now I have a better understanding about it!"
Ben Masters
VIC, Australia
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> Options Guide >
Option strategies |
Option Strategies
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Hedging Strategies - One of the
basic reasons investors (especially institutions
that manage large funds) use Options is for hedging
purposes.
Imagine that you've bought some shares of
a particular stock, which you expect to rise.
However, there might be some uncertainty as
to whether it will actually rise, or drop
instead.
One thing you can do to hedge - or protect - your
investment would be to buy a Put Option on that
stock. (Remember, you buy a Put Option when you
expect the stock price to go down). So you are hedging
your stock by buying a put option on it.
If the price of the stock goes up, your Put
Option expires worthless, but your original
stock investment will be giving you profit.
If the price goes down, your losses in your
stock investment will be reduced by your Put
Option, which will be worth more as the price
drops.
These hedging strategies will lower your profit
slightly, since you need to spend extra to buy the
Put Option for hedging, but they give you a safety
net in case your stock goes down.
Hedging strategies are suitable for mildly bullish
stocks, where you expect the stock to go up, but
fear that it might go down. If you think the stock
will go down, you would not use hedging strategies.
You would sell the stock and just buy put options.
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To protect your
stock investment, you implement hedging
strategies by buying Put Options
on the stock. This will limit your losses
if the price drops.
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Trading
Options - So far, the only option strategies
we have touched are about buying options, and then
exercising them or letting them expire worthless.
However, the majority of investors do not actually
hold their options until the expiration date. They
do what's called "Option Trading".
When you buy an option, you are considered
to be Opening a Position by purchasing
the option. There are 3 ways you can Close
the Position:
- Firstly, you can exercise the option
before the expiration date to buy the underlying
stock.
- Secondly, you can let the option expire
worthless, i.e. don't do anything.
- The third and most popular of the option strategies
would be to sell the option.
Buying options is like buying stocks. You
buy them on the open market, where there will be
other people buying and selling the same options.
As such, there will be Bid and Ask
prices for options, same as for stocks.
A new term to remember when looking at option strategies
is the Open Interest. This represents the
number of Open Positions there are for
that particular option. If the Open Interest is
zero, it means either that nobody has bought that
option, and/or that the people who previously bought
it have Closed their Positions.
Let's look at trading option strategies with
our previous example on the ABC company:
To recap, we bought an option on the 1st of
June for the ABC company, when the stock was
trading at $19.00. We bought the June option
with a strike price of $20.00, at a premium
of $0.75.
We now have an Open Position on the ABC $20
June Call option.
Let's assume that a week later, on the 8th
of June, the price for the ABC stock has gone
up to $24.00. That means our option is now
In-The-Money by $4, since our strike price
is $20 and the current value is $24, allowing
us to theoretically exercise the option and
buy the stock at $20, and immediately sell
it at $24 for a $4 profit. (Remember that
since we are trading American Options, we
can exercise anytime before expiration day.)
However, a more convenient method (and cheaper
too, since we don't have to spend the $20
to buy the stock), would be to sell the option
to someone else. Since the option is now In-The-Money,
its premium would have risen quite a bit too,
say to $4.50. That is the price we can sell
the option at.
We don't have to worry about finding someone
to buy the option from us. The American options
market has Market Makers who will
maintain market liquidity, i.e. they
will make sure all buyers will find corresponding
sellers, and vice versa.
So we will sell the Call Option at $4.50.
Since we initially paid $0.75 for the option
premium, we have just made a profit of $4.50
- $0.75 = $3.75. In case you were wondering,
that's a 400% profit on our $0.75 investment.
Congratulations!
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| ABC |
1st June |
8th June |
| Current Premium |
$0.75 |
$4.50 |
| Strike Price |
$20.00 |
$20.00 |
| Expiration Date |
3rd Friday |
3rd Friday |
| Current Stock Price |
$19.00 |
$24.00 |
| In-The-Money? |
Out by $1 |
In by $4 |
| Profit |
- $0.75 |
$3.75 |
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Be aware
that the stock price could just as easily have gone
down, which would result in us losing our entire
$0.75 premium. Be careful, most option strategies
are risky!
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