24 January 2024
As the investment world becomes increasingly technical, you can now use option derivatives for hedging, income generation or speculative investment purposes. While taking advice if you are inexperienced in this area is essential, using options can help you replicate any investment strategy and attitude to risk. So, where do we start?
Yes, it is a fundamental question that needs answered even if 99.99% of those reading this article will know the answer already. When it comes to options, there are two main derivatives, call options and put options.
A call option gives the holder the right, but not the obligation, to buy an asset at a predetermined price over a predetermined time period.
Put options give the holder the right, but not the obligation, to sell an asset at a predetermined price over a predetermined time period.
To secure an option to buy or sell, you will pay what is known as a premium. Due to how options are structured, it is possible to leverage a relatively small amount of funding to take control of a significant amount of an underlying asset.
Many institutional investors will use hedging to protect their portfolio, buying a put option that allows them, for example, to sell an index if it falls. If your portfolio were to mimic an underlying index, any fall in your portfolio would be offset, if structured correctly, by an increase in the value of the put option.
Cost of hedging: The premium paid for the option to sell at a specific price over a particular time period.
It is possible to earn regular income off your portfolio by doing what is known as covered calls and cash-secured puts. With a covered call, you sell a call option against your holding, giving another investor the option to buy your stock at a predetermined level. If the stock stays below the option strike price, it will expire worthless, and you will take the premium as income. If it goes up, you sell at the fixed price and also keep the premium.
You can also earn income by selling put options in a stock that you are looking to invest in, but you may not yet have sufficient funds to carry out your purchase. After identifying a price you would be comfortable buying and holding in the long term, you sell a put at this price.
If the stock falls below the put option price, the holder will sell the shares to you, but if the stock price remains above the put option price, it will expire worthless – either way you will collect the premium as income.
You can also use several relatively complex strategies to take advantage of market volatility or a lack of it. These include:-
The purchase of a call option and a put option on the same stock with the same strike price and expiration date is a gamble that the shares will be volatile. Your total premium would be the cost of the call option and the put option. So if they cost 20p per share combined, you would need a 20p movement up or down to break even, and anything beyond those levels would be a profit.
Similar to a straddle, this type of option involves buying a call and put with different strike prices, typically significantly above and below the underlying stock price. As these options are cheaper, significant upside and downside volatility would leverage the options' value. Still, this strategy does require more substantial movement in the stock price.
You can create a bull spread, bear spread or calendar spread, which involves buying and selling options of the same class (calls or puts) on the same asset but with different strike prices or expiration dates. The calendar spread version also plays on the time element attached to longer-dated options.
A butterfly spread allows you to buy call options below and above the current stock price; selling puts at a middle price (the quantity of put options would be the combination of the two call option positions). A neutral strategy, this allows you to benefit from the put premiums if there is limited movement, but if the stock did move significantly, you are covered by the buy options.
A condor spread is similar to a butterfly spread, except you would have four different strike prices, buying an option at the lowest and highest strike prices and selling options at two middle prices. The maximum profit is realised if the stock is between the two middle option strike prices on expiry. The highest losses, which would be limited, would occur if the stock price was below the lower strike price or above the higher strike price.
Butterfly and condor spreads are popular amongst investors who believe there will be limited movement in a particular stock or index.
As simple or as complex as these strategies are, they work on the same premise; there is always a limit on the downside. It is also essential to take on other issues, such as:-
· Margin calls
· Decay in time value
· Volatility premium
It is not difficult to see the potential movement in the volatility premium if markets were prone to wild swings.
As you can see, there are several different strategies you can use to effectively "hedge your bets", even though many people see the word hedge and automatically assume an open-ended risk. In their most basic form, options can be used to take speculative risks in a market, but there are numerous additional strategies you can use to minimise any potential downside while, in some cases, leaving unlimited upside.
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