10 ways to trade options

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Options are very flexible financial tools that can fulfil many functions in the investor’s toolbox. Options can be used to hedge or protect an existing position. Or they can be used to speculate relatively cheaply with the prospect of huge, leveraged profits. Or again as a means to create new exposures to more complex factors, such as the volatility of the price of an asset, rather than an exposure to the price itself. Let’s consider some of these uses in more detail.

1. Using options to hedge an existing position

A classic use of options. If the investor owns an asset and is concerned about say a large fall in its price, he can consider buying some put options. For a small premium he can then protect the position against losses below the strike price of the puts.

2. Trading options to create a hedge at no cost

The cost of the hedge discussed in 1. can be offset by selling a different option. For example, selling a call option in order to pay for the purchase of a put option. The put option is the hedge against a fall in the asset price. Selling the call option will limit the profits from a rise in the asset’s price above a certain level (above the strike of the call) but if this is acceptable to the investor, it can be a way of financing the purchase of the put option.

3. Enhancing the yield on a portfolio

A little like 2. without 1! For example, if the investor owns an asset and he would be perfectly satisfied with a 20% increase in its price in the next 12 months, he could consider selling a call option with a strike 20% above the current asset price. If the price doesn’t rise by 20%, the call will expire worthless and the investor collects the premium from selling the call option. This can be viewed as a form of yield enhancement on the portfolio. Of course, the flip side to selling this call is that the profits from the asset price rising by more than 20% may be lost or curtailed. But this is the trade off the investor must consider at the outset.

4. To gain exposure to the expected volatility in an asset’s price

A key factor in the value of an option is the expected level of volatility in the underlying asset’s price during the life of the option. This is known as the implied volatility of the option. For example, suppose the current price of options on an asset imply that the volatility of the asset’s price over the next 12 months is expected to be 20% (i.e. the implied volatility of the options on the asset is 20%). If the investor thinks this expectation is likely to change, he can buy or sell options in order to profit from this.

5. To gain exposure to the actual volatility in an asset’s price

If the actual realized volatility in an asset’s price differs significantly over time from the expected level of volatility implied by the price of options, it is possible for the investor to trade options and profit from this difference. For example, suppose options currently imply the asset’s price will move with a volatility level of 20% over the next 12 months. But suppose further that the investor think the asset’s price will be far less volatile than this. The investor could sell options on the asset and then, by hedging appropriately, look to profit from the discrepancy between the implied volatility and the realized volatility.

6. To act as an insurer and collect a premium

Selling options can be compared to acting as an insurer. By selling (or as it is also known, writing) options, the investor is offering the buyer of the options protection against some kind of movement in the price of the underlying. Some investors use options to insure other traders against unlikely events, in order to collect the ‘insurance’ premium. This can be a risky strategy, as losses can be large if statistically unlikely events occur. However, if the investor is happy with the risk profile that being an insurer entails, then options can be used as the vehicle to assume this position.

7. To take a low-cost directional position with the potential for huge profits

Options that are not currently in-the-money, for example call options whose strike is above the current underlying asset price, can make for a low-cost way to gain exposure to large moves in the asset price. If an investor expects the price of an asset to rise (or indeed fall) sharply, then buying an out-of-the-money option can be a way to capture profits from such a move. One of the attractions of this way of trading options is that the loss is limited to the amount paid for the options, whereas the potential gain can be several multiples of the amount expended.

8.  To collect option premium through time decay

Slightly more technical, but easily explained. The value of an out-of-the-money option declines over time, other things being equal. This is simply because any option  (whether financial or otherwise) is more valuable, the longer it is valid. So as time passes, options generally become less valuable. Some investors look to profit from this fact by writing (i.e.shorting) options. The risks to this strategy should be properly understand, but this is certainly one way of trading options.

9. To construct a portfolio that varies over time

There are often several options to trade an underlying asset which have different expiration dates. As a result, it is possible to use options to construct a portfolio which reflects the investors preferences with respect to the price of an asset combined with timing. For example, if the investor feels the asset price is likely to be relatively static for the next few months but then experience a sharp up-move in price, then using options of differing expiration a portfolio can be built to profit from this outcome. Options are ideally suited to this kind of temporal preference-matching.

10. To construct a complex payoff profile

Options can also be traded to reflect an investors preference with respect to the price of an asset, no matter how complex this might be. In fact, options are ideally suited to this kind of portfolio building. For example, suppose the investor thinks the price of an asset will trade within a certain range for the next 3 months, but that if it does experience a sharp price move then it will be to the downside but no lower than a certain level. It would not be hard to put together a package of options on the asset which accurately reproduce this price action profile and ensure that the investor has the best chance to profit from his expectations, should they be proven accurate.

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