How Options Can Play a Role in Your Investment Strategy

Options are an underutilized investment tool that is overlooked because they seem complicated and are perceived to be for the exclusive use of professional traders. But once they are properly understood, the average investor may come to realize how options can play a role in their investment strategies.

Options Recap

An option gives an investor the right (but not the obligation) to buy or sell a stock at a given price, on or before a predetermined date. The right to buy a stock is known as a call option, while the right to sell a stock is called a put option.

As an alternative to exercising the option and buying or selling a stock, the option contract can be sold back into the market for a profit.

Options as a Hedge

Options can act as a hedge against near-term volatility by providing investors an insurance policy against downside movement.

Suppose that an investor is holding 100 shares of XYZ Corp., a gold mining company that is trading at $31 per share. 

The investor has some near-term concerns about the direction of gold prices and wants to avoid seeing this holding drop in value. To protect the stock holding on the downside, the investor takes a proactive approach by buying one put option with a $30 strike price that expires in one year, for a total cost of $100.

If gold prices plummet and shares of XYZ Corp fall to $20 per share, the investor will not incur a major loss. This is because the investor’s put option gives him or her the ability to sell the 100 shares at $30, regardless of the current price of the stock.

If the stock does not drop in value, the put option will become worthless on expiration. The investor will lose 100% of the put option, but this is precisely the logic behind an insurance policy: it kicks in only when needed.

Options as an Investment

Call options can be used by investors to profit from a stock that is expected to gain in value.

Suppose that an investor is bullish on ABC Inc., a fast-growing financial services company that is trading at $250 per share. The only problem with buying the stock outright is its high cost. Purchasing 100 shares is not an option, given the investor’s budget.

Instead of buying the stock, the investor can buy one call option with a $350 strike price that expires in one year. If the investor’s thesis is right, the value of the call option will increase in step with the stock.

On the other hand if, after one year, the stock does not reach at least $350 per share, then the call option will have lost all its value and expired worthless.

Drawbacks to Using Options

The major drawback with options is that they offer no credit simply because an investor has been right about a stock’s direction. If shares of ABC Inc. rise from $250 per share to $340 per share, the investor is technically on the right side of the trade. But if the stock does not break above $350 per share, the investor will lose the entire value of the option once it expires.

By contrast, an investor who buys the stock outright is not subject to any time constraints. If the stock was bought at $250, the investor will have generated a respectable return of $90 per share.

Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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