In the last two weeks, we discussed how options are priced and the various factors that affect option prices. In this and next week's article, we'll discuss some commonly used option trading strategies. In general, there are four different option positions we can hold. We can be long a call, short a call, long a put, or short a put. For retail investors, going short a call or put may not always be possible given the high risks involved in writing options. It is easier in certain cases (such as covered calls which will be discussed later)
The most basic option strategy is to buy a call or put option depending on our view of the underlying asset. If we think a stock will rise over the next year, we can buy a one year call option on the stock. If we think the stock will fall, we can buy a one year put option on the stock. Let's take a hypothetical example of company XYZ. XYZ has a current market price of Rs. 100. There is a one year ATM call option on the stock trading at Rs. 10, and a one year ATM put option also trading at Rs. 10. If we think the stock will rise, we can buy a call option on the stock. Let's examine the risks and rewards with this strategy. The rewards are unlimited, much like owning the stock itself. We can keep making a profit as the stock price rises. The only issue to keep in mind is that the time value of the stock will eventually fall to zero upon expiry. If the stock ends up falling, the maximum amount we can lose is Rs. 10 (the price we paid for the option). This is beauty of an option in that no matter how much the stock price falls, our loss is always Rs. 10 and nothing more. The final risk associated with the strategy is that the stock price will do nothing. If after one year, the stock is still priced at Rs. 100, our option will expire worthless. We'll have lost Rs. 10 despite the stock not moving. The important thing to remember is that when using options we must have a view on the time it will take for the stock to rise (rather than just the direction of the stock). In the example above, if we're going to use the call option, our view must be that the stock will rise within a year, rather than it will simply rise.
The next strategy I'd like to discuss is called a protective put. It is a hedging strategy that is used when one owns the stock itself. In a protective put, we own the underlying stock, and we buy a put option on the stock. The reason for this is that if the stock price falls, the loss we incur from holding the stock will be offset by profits from the put option. If the stock price rises, we will gain from holding the stock, but lose the premium paid for the put option. So when should such a strategy be used? First, assume we are holding a stock because we believe it is undervalued and will rise in the long term. Second, we also think that this company is quite high risk, and there's a chance the stock could fall dramatically. A protective put would be an ideal strategy in this case. It is much like purchasing an insurance policy. If the stock price rises like we expected, we make a profit from holding the stock, and we lose the premium we paid for the put option (i.e. the insurance premium). If the stock price ends up falling, the profit from the put will offset any losses from holding the stock.
The last strategy I'd like to discuss is also applicable when one owns the underlying stock itself. It is known as a covered call. The purpose of a covered call is to enhance one's income in exchange for upside profit potential. In a covered call, we own the stock, and simultaneously write an OTM call option on the stock. An example should help illustrate this. Company XYZ is trading at Rs. 100 and at 3 month OTM call option with a strike of Rs. 105 is trading at Rs. 3. We are holding stock of company XZY because we believe it is undervalued and will rise in the long term. However, in the near term we expect that the stock will not go anywhere. We can write (i.e. sell) the 3 month call option and earn Rs. 3. If the stock price stays below Rs. 105 over 3 months, the option will expire worthless and we get to keep the Rs. 3 premium we received when writing the option. What are the risks? If the stock price goes above Rs. 105, the option will be in the money and our stock will be called away (i.e. we will have to sell our stock to the option holder for Rs 105). This is what is meant by exchanging upside potential. We have committed ourselves to selling our stock for Rs. 105 to the holder of the option, so we will not benefit if the price rises above Rs. 105. If the stock price ends up falling, we will lose money from holding the stock, but it will be partially offset by the premium received from writing the option. The purpose of a covered call is to earn additional income when we expect the price of the stock to stay the same.
When considering the above described strategies, it is important to have an idea of one's objectives. Directional strategies should be used when one has a clear belief of which way prices will go and how long it will take to get there. One of the main advantages of options is that the investor only needs to put up a small amount of money (relative to buying the stock itself). If an investor already owns the underlying stock, protective puts can be used as insurance against a stock price fall. Covered calls can be used to enhance one's return if the stock price is expected to stay flat. Next week, we'll discuss some more advanced trading strategies that we can apply through the use of options.
This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!