Equity options have been gaining, like other derivatives, a lot of ground in recent years. They have many uses and can be used to complement a portfolio management strategy. However, they are risky instruments and must be used with great care. Since we have received several questions about options, we decided to write a little about what they are, how they work and how you can use them.
Equity options are as you can guess an “option” to buy or sell a given amount of stock at a given time for a given price. You will see call and put options. Simply, call options are the option to buy while put options are options to sell. In every such transaction, there is of course a buyer and a seller of an option.
The best way to understand how these products work is to compare them to lottery tickets. If you buy a lottery ticket, you cannot lose much, you can only lose the value you paid for your ticket. However, if you sell one, then you might be in for a big loss. The same applies to options. Buyers have a limited loss while in general sellers have a much greater potential loss.
The price that will determine if the option is exercised (lottery ticket is won) is the strike price. The price of the stock is greater then the strike price, then the call option (buy) would be exercised while the opposite is true for put options. And finally, the options have a maturity, a month at which time the option becomes worthless. The specific day is the 3rd Friday of that month.
Here are a few strategies that could be used with options:
-Long call: A risky but simple gamble. Basically, you will be able to take a much greater position in a stock you believe will rise because you are not paying for the stock, only for the option. However, if the stock does not rise, you will lose your money.
-Long put: same for a stock you believe will go down
-Covered call: This strategy had been discussed in a previous article (a play on volatility – it has returned 3.5% so far) – you use this when you already have a stock, and want to gain additional return. The risk you have is that you might sell your stock for less than it is worth but the upside is more money in your pocket every time you use it
-Protective put: Let’s say you felt a few months ago that some of your stocks might have a steep decline (yeah, you are smart in that way), you could have bought a put option, which in effect is a like buying an insurance for your portfolio in case of a downturn…
A lot more could be discussed but this was a good start wasn’t it? In the meantime, you can always check out Market Club Video section about options (see add below)
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