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Option Strategies

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.

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.

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!

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

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!

Topics in this Guide

  1.  What are options
  2.  Calls and puts
  3.  Options lingo
  4.  Option strategies
  5.  Straddles
  6.  Covered calls
  7.  Spreads

3. Options lingo

5. Straddles

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