- Defining what your book needs when trading options
- Long & short positions using options
- Hedging your outright positions using options
Determining Our Needs in The Use of Options
Options like many financial instruments may be used to simulate outright cash positions or as a way to defend against losses in an existing investment or speculative position. As a trader or investor you most likely already have a well-designed plan to execute your trades or investments. However, you may still be looking to gain extra exposure to the financial markets you deal in, without using up to much margin to cover these positions. Or, you may be looking to cover the risk of some positions you have due to a changing market view, without having to close your cash positions.
Options take up considerably less capital than a cash position, as the whole position is covered by the cost of a buying a Call or Put, although selling options requires more cash on margin. The high level of leverage makes options a highly margin-efficient financial derivative, particularly when buying them.
If you’re speculating on stocks on a short-term horizon, hedging those positions with extremely short-term options may prove tricky, and ultimately bite into your profits for little upside. Whereas, you might find options useful to take a longer view on a given stock or index. The high leverage means you can take a much larger position than the cost of the option and for a time horizon going into weeks rather than days.
As an investor, you may be looking to hedge some risk if events turn the stock market more volatile, and you don’t want to sell any of the stocks in your portfolio. Buying Puts for a long stocks portfolio can help recover some losses in times of market distress, but will come at a cost if the market does not see the feared correction. You can also choose to add a speculative element to the portfolio, if you feel the market is going to see a large correction then you can buy Puts that cover more than you portfolio longs, essentially creating a speculative short position. You could also add a speculative long position through buying Calls.
Long & Short Positions Using Options
Speculative trades in options may involve any type of option contract and position; long or short on Calls or Puts, or any combination. Fundamentally the easiest positions to take are buying Calls or Puts, or buying them both simultaneously. For the speculative trader, it is fairly simple to monitor a long Call or Put and to understand the dynamics which lead to profits or the loss of the cost of the option.
For speculative traders, it is also important to understand the concept of volatility. Rising volatility can greatly increase the cost of an option, the same way declining volatility will reduce the value of an option, even when the underlying market is going in favor of the option. So, in times of expected increases in volatility, it is usually best to be long options rather than short.
Buying both Calls and Puts allows for a trader to speculate on volatility moves. If you feel the market is about to take a new direction, usually after a period of sideways price movement, then this combination can be very effective. This type of combination usually works best on FX markets or commodities as volatility increasesare independent of market direction. In stocks, volatility actually decreases when the market rises, and rises when there is a correction. This asymmetry is due to the fact that usually increases in price are smaller and extended in time, whereas, corrections are more violent and happen quickly.
Using Options to Hedge Outright Positions
Investors typically use long Put option plays to cover the possibility of losses on their long-only portfolio. This is fairly straight forward, but there is also another way to hedge a long-only portfolio if you feel the next move is going to be sideways.
Buying Puts, while it does protect your downside from large losses, also comes at a cost and reduces the performance of your outright positions. On the other hand, selling Calls, covered Call selling in stocks, allows you to gain revenue and increases the performance of your outright position although your profits are limited to the Strike of the Call plus the premium.
A third possibility is buying Puts and selling Calls; this allows you to reduce the cost of purchasing the puts, increasing the overall performance of the portfolio. If you are willing to limit the profit on your long position, then you can buy a Put with a similar cost of the revenue generated in selling the Call option, creating a very cheap or near costless hedge.
In in the last two examples, a sideways market is what will benefit the investor most. A long Put position will have its cost but if the market rally is strong enough it will be more than paid for, while a loss, although it may be smaller, may be incurred in a large market correction. A sideways market will allow a short Call position to make money while the value of the underlying position remains little changed. If the market were to experience a strong rally, then the underlying position would be limited by the Call itself being exercised. The long Put and short Call also benefits the most from a sideways market, if the markets rally then the profits are limited by the short Call position, however, if the market crashes the losses are limited by the long Put position.
What you need to know are your requirements for your options positions and the effect of volatility on option values. You need to understand what you are trying to achieve with your option position; simple long-only positions may be all you need. However, there may be other combinations worth looking at also. Worth reminding finally; long positions in a Call may not always generate a profit when the underlying market is stocks, even if the price of the stock is going up.