Stock options offer investors limited downside in pursuing speculative trading strategies. Stock options also offer the ability to hedge existing positions and to minimize risk. Stock options are important in many advanced trading activities. Investors can make money as both a call writer or a call seller depending on market conditions. Stock options enjoy great leverage with a minimum downside risk.
Working of Options
Suppose a stock is trading at 50. A trader believes the stock will go to 60 but want to limits your risk. The trader buys a call option, which gives you the right but not the obligation to buy the stock at 55. You pay a market-derived premium of two points for the contract. If the stock rises at or above the strike price of 55, you gain dollar for dollar with the rise of the stock. If the stock does not reach 55, your loss is the entire two points. If the stock drops to 45, you have avoided a five-point loss but still have lost two points from the initial investment. This is an example of a speculative trade. The trader wants to participate but with only a limited risk.
Covered Call Writing
Options are important because they allow investors to receive income. The trading strategy is called covered call writing. This is a popular strategy for insurance companies. For example, a call seller can write an option in which the investor thinks the stock will not vary in price. He receives income for the transaction in the amount of the premium. The investor must be willing to lose the stock if the price rises. To do this trade, the investor must own the underlying stock that the option is being written on. Covered call writing is important in stock options trading because the total return of the stock option is so much better than that of bonds or money market funds.
Hedging Stock Positions
Investors will hedge existing stock positions with stock options. Suppose a hedge fund investor has profits that she does not want to take in the current year. The trader can write puts, which give the trader the right but not the obligation to sell stock at the strike price of the option. The trader writes the option to expire in January thus avoiding the potential decline in the value of the stock through year end. This eliminates the need to sell a stock position and take gains in the current year. Increased intermediate and overnight hedging is an important part of trading.
Hedging Stock Positions for Intermediate Corrections
Hedging a stock position in anticipation of a downward market move is probably the most common and important stock option activity after speculative trading. An investor is holding a large position in a stock but expects near-term weakness. The trader can write puts and, for the limited cost of the premium, be protected dollar for dollar if the stock declines. Commonly used by hedge funds to offset risky stock with great volatility, hedging allows the trader to continue owning stock through short and intermediate downturns.
Leverage and Limited Risk
Options are expensive if they are not exercised. All the option premium accrues to the option seller. Depending on option strike price and maturity, however, the option buyer is usually margining the amount at risk by 15 to 20 times for the period until option expiration day (the third Friday of every month). This great amount of leverage allows large profits to be made if the market direction or a particular stock performance is recognized. Option trading is important because it has the net effect of increasing market liquidity and creating a meaningful way to reduce risk.