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Hedging & Speculating

Types of Option Traders:

There are two different types of options traders: hedgers and speculators. All have different strategies that can be used to generate different returns and minimize downside risk. 

Hedgers:

Let’s first look at how options can be used to protect from adverse movements in the market. A trader who owns 1,000 shares of Nvidia believes that the price may drop dramatically in the next month and would like to protect their investment.

The trader decides to purchase 10 NVDA put contracts to protect their position from any large downward swings in price for a comparatively small fee. Since an option contract is made up of 100 shares, 10 contracts is able to cover the entire positions (10 * 100 = 1000). Remember, put options give the holder of the option the right to sell the underlying security for a specified price within a predetermined time frame.

Nvidia is currently trading at $157 per share and the trader has decided to purchase 10 $155 put options that are currently trading at a premium of $2.50. In total, the trader bought the 10 puts for $2,500, or (10 * 100 * $2.50).

In the next month, if NVIDIA were to drop to $140, the holder of the put options would be able to sell their shares for $155 instead of $140, protecting them from much of the potential downside they could have faced.

Had the trader not purchased the protective put options, they would have faced a loss of $17,000, instead they were able to protect their position for the comparatively small sum of $2,500. Had the stock not traded below $155 in the time period the options would have expired worthless but the trader had the peace of mind that they would not face substantial losses and still enjoys any upward movements in price. a

Speculation:

While hedging is used to protect from downside movement, speculators use options to bet that the market will move up or down.

A speculator might decide to go long on Albemarle, believing the company should be rapidly growing in the future due to increased demands in Lithium and as a result the stock price will dramatically rise.

Albemarle is currently trading at $115 and the trader believes we could see $120 in the next 3 months, a substantial increase in price is a short period of time. The premium on $120 call option is $4. The trader is only willing to allocate $5,000 to this trade and is weighing buying options or buying shares of stocks. Let’s see compare the pay-offs in a speculative play.

The first scenario involves the trader purchasing 43 shares of Albemarle at $115. The total amount spent is $4,945.

The second scenario involves the trader purchasing 12 $120 call options for a premium of $4. The total amount spent is (12 * 4 * 100) = $4,800.

AlbeMarleSpeculation

It’s easy to see that by buying options and the stock price moving in the right direction the trader was able to maximize their return, but at the same time faced a vastly larger potential loss had the price dropped. Options are a great way to increase leverage but with great reward comes great risk. A speculative trader should never take out a position that they can not afford to lose on as the probability of a trade moving in the right direction can be slim.

Options Trading Basic

Introduction to Options

You might have heard a lot about trading Options. Some thoughts that typically come to mind are risky, get-rich-quick, leveraged or highly volatile but when traded according to specific strategies they can reliably generate income, limit your downside risk in other trades or be used in speculative plays.

In the simplest of terms, options are an agreement between two parties to buy or sell an underlying security, most commonly stock shares, at a specified price within a defined period of time.

Options are a type of derivative security, financial instruments that derive their value  from other more basic, underlying variables. Options are traded on many different types of securities including stocks, stock indices, debt instruments, commodities and futures contracts. Options on equities and futures are most commonly traded and are most on most every major stock. 

There are two basic types of options, call options and put options:

Call option: A call option gives a buyer the right to purchase an underlying security at a certain price within a certain period of time. Purchasing a call option is similar to being long, or believing the price will rise, on a stock.

Put option: A put options gives a buyer the right to sell an underlying security at a certain price within a certain period of time. Holding a put option is similar to being short, or believing the price will drop, on a stock.

It’s important to note that options give the holder of the option the right to buy the stock but not the obligation to buy the stock. On the other hand, sellers of call and put options are obligated to either buy or sell if the holder of the contract exercises the option.  

The price that the holder of an option can buy or sell the underlying security at is known as the exercise price or strike price. When purchasing an option a premium is paid per share, similar to a down-payment. 

The expiration date in an options contract is known as the exercise date or by maturity.

American Options can be exercised at any time up to the expiration date while European Options can only be exercised on the expiration date. American and European options do not refer to the geographical location of the option but the nature of the expiration date, majority of options that are actively traded are American options.

When someone purchases an option they aren’t purchasing an option on just one share but 100 shares. Options are traded in contracts and an options contract is typically an agreement to buy or sell 100 shares of the underlying asset. The premium paid is paid per share, so a premium is paid on 100 shares. 

Options aren’t a one-way street, when you buy a call option someone has sold you the rights of their shares within a specific period. Why would someone want to relinquish the rights to their stock? Option traders who sell options, often referred to as writing option contracts, collect a premium that is paid to control each share within the contract. They are either comfortable with selling their stock at the agreed upon price, believe the price may move up or down and are collecting premium to generate additional income and cushion any losses, or may be selling options as part of a more advanced strategy.

Why do options gain in value?

Options have value because of two main factors, time-value and intrinsic value. There are more complex ways of valuing options but for the purpose of this article these are the factors that will be focused on.

Intrinsic value: If a call option has a strike price of $50 and is currently trading at $54, there is $4 of intrinsic value that could be captured by exercising the option, purchasing the shares for $50 and then selling them at $54 a share.

Time value: All options have a specific time period in which trading prices must meet their strike price before they expire. Time is your enemy as the holder of an option contract, as there is less and less time before expiration, the probability that the stock will make a move in the right direction becomes less and less, devaluing the option.

Time value is worth the difference between the intrinsic value and the premium.

As options moves towards or away from their strike prices, the value of the premium increases or decreases and as time to maturity decreases the value of options decreases. Option prices decrease more rapidly the further away from the strike price a stock is and remaining time to maturity becomes smaller.

Time Instrinsic value

Moneyness:

In-the-Money or Deep-in-the-money: When a stock is trading higher than the strike price of an option. Say a call option has a strike price of $50 and the stock is trading at $54, there is an intrinsic value of $4 per share in the option contract.

The further, or deeper in the money, and option is the more valuable the premium on it becomes because of the intrinsic value.

At-the-Money: When a stock is trading at the same price as the strike price.

Out-of-the-money or Deep-out-of-the-Money: When a stock is trading below the strike price. Say a call option that has strike price of $50 is currently trading at $44, the stock would have to move upwards by $6 within the remaining time to expiration before the option would have any intrinsic value.

The further out of the money an option is the less valuable it becomes because a bigger moves towards the money is required and time to maturity is always decreasing.

Example:

Lets check out two different scenarios that give more clarity as to how options work.

Call Option:

Consider the following scenario. A trader is considering purchasing a Call Option on IBM at the strike price of $150 with an expiration date one month in the future. IBM is currently trading at $147 and the current premium to buy an IBM call option is $3.30.

To purchase this call option the trader would have to pay a premium for each share in the contract, meaning the trader must lay out $330 to purchase one contract.

Price of Call Option =  Number of Options (100 * Premium)

Price of IBM Call Option = 1 (100 * $3.30) = $330

For this trade to breakeven, IBM’s price needs to raise above $150.30 before the expiration date in one month. If the stock price does not raise above $150 the option will expire worthless. It doesn’t make sense to purchase a stock for $150 if it is trading below the strike price at or before expiration and the trader would lose the entire value of the option investment.

If the stock is trading at $155 at expiration the trader would exercise the option and purchase the shares or sell the option to capture the intrinsic value of the option.

Call Option Profit = 100 * (Current Price – Strike Price) – Premium Paid

IBM Call Option Profit = 100 * ($155 – $150) – (100 * $3.30) = $170

The trader risked $330 and profited $170 when exiting the trade, not counting for transaction costs. That’s a pretty great return on investment in just a month.

Return on Investment: ( Gain from Investment – Initial Investment) / (Gain from Investment)

Return on Investment: ($500 – $330) / ($500) = 34% return

LongCall Graphic

Put Option:

Consider the following scenario. A trader is considering purchasing a Put Option on IBM at the strike price of $141.50 with an expiration date one month in the future. IBM is currently trading at $144 and the current premium to buy an IBM put option is $1.50.

To purchase this put option the trader would have to pay a premium for each share in the contract, meaning the trader must lay out $150 to purchase one contract.

Price of Put Option =  Number of Options (100 * Premium)

Price of IBM Put Option = 1 (100 * $1.50) = $150

If the stock price does not drop below $141.50 the option will expire worthless.

If the stock is trading at $138 at expiration the trader would exercise the option and purchase the shares or sell the option to capture the intrinsic value of the option.

Put Option Profit = 100 * (Strike Price – Current Price) – Premium Paid

IBM Call Option Profit = 100 * ($141.50 – $138) – (100 * $1.50) = $200

The trader risked $150 and profited $200 when exiting the trade, not counting for transaction costs. That’s a pretty great return on investment in just a month.

Return on Investment = ( Gain from Investment – Initial Investment) / (Gain from Investment)

Return on Investment = ($350 – $200) / ($350) = 34% return

Another great return that couldn’t have been made by just purchasing the stock.

ShortPut Graphic

Summary:

One of the real benefits that comes from trading options is limited downside and potentially limitless gain.

With our call option trade on IBM we only outlayed $330 and for that amount we were able to control 100 shares of IBM. To purchase 100 shares of IBM at $147 we would have to have paid out $14,700 to buy that many shares. Had IBM gone bankrupt we could have lost $14k, but our maximum loss would have been limited to the premium paid to the seller, and we had ownership over any of the profits above the breakeven price!

Stock options can provide great leverage and great returns if a trader manages their risk and sticks to a strict set of trading guides! What makes-or-breaks most traders is their inability to stick to the rules they set upon themselves and getting caught up in speculating look to get-rich-quick.

The best option strategies will be laid out on this website so keep reading and gaining experience and you’ll be on your way to generating reliable income and living the lifestyle that you have always dreamed of!