Hedging With Options

If you have been getting stock options explained to you via this stock options guide, it should be pretty clear by now there are many ways to use options that do not involve increased risk, that in fact serve to reduce overall risk in our portfolio. In a nutshell writing calls and puts usually gives us this ability. In the largest sense, writing options is about hedging, taking the safer side of a transaction in which the person on the other side of the trade is achieving leverage.

As leverage (such as one can achieve by buying calls and puts) is all about making huge gains on a usually smallish amount of money, hedging (e.g. with options) is about achieving rather small percentage gains on (usually) existing positions that are often quite large. If my aim is to explain stock options basics then I must cover both sides of options transactions- the buy (long) side and the sell (short) side.

Hedging can be a better strategy than simply holding a position and being fully exposed to a possible price downturn. Farmers use the commodity markets to ensure that they get a certain price for at least a portion of their crop, guarding against possible lower prices for a not-yet-harvested crop.

We can do this with stock options by selling someone a right to purchase something we own at a higher price, with the stipulation being that if the market never takes the price that high, by a certain date, that we keep the money that we got for selling that right in the first place.

With stock options you can create an income by selling calls with a strike price higher than the current price of the stock, against shares that are already in your portfolio. If you’re not ready to sell your stock in a given company at its current price, but would be happy to sell it at a higher level, simply write a call for each 100 shares of stock you own, with a strike price at which you would be satisfied to sell. In this way, if your shares continued to rise and the price is higher than the strike at expiration, your call will be exercised and you will deliver the shares at the strike price. If your shares are not priced above the strike price at expiration, the calls that you have written will expire worthless and you will simply keep the premium amount that you received for writing them (as well as your shares, of course). Many, many savvy investors with large portfolios make nice rates of return in this way, against stock that they are still bullish on, but could be persuaded to sell at higher levels. The downside of this strategy is that as you are obligated to sell at the strike price, assuming the call is in the money at expiration, you would miss out on any further rise in the price of the stock beyond the strike price.

The concept is exactly the same with puts incidentally, except reversed: for stock that you are short and still bearish on, but interested in hedging, you could write a put contract for every 100 shares that you are short and would like to include in the position, puts with a strike price at which you’d be satisfied in covering your short shares. If at expiration the stock is above the strike price the puts will expire worthless and you will keep the premium, and if this stock price is below the strike price, you’ll simply be forced to cover the applicable shares at the strike price.

Why Options Selling Increases Safety

If you are a new investor looking to diversify your portfolio for the sake of safety, chances are you haven’t really taken a look at stock options for a couple of reasons. First, you might be a little intimidated by the complexity of options. Secondly, you probably associate options with a high level of risk, and this gives you little incentive to scale a learning curve as you’re interested in protecting your money in these uncertain times.

The thing is that buying stock options is only one option trading strategy you can use. Instead of buying an option, which is the right to purchase 100 shares of the stock at a given price point by a certain date in the future, you can take the other side of the trade and sell an option contract that covers shares that you already own. Options selling is usually overlooked by new investors, and this is a mistake.

Here’s what you need to know: options selling means is that the option buyer pays you a small amount of money-known as the premium-for the right to purchase your shares at a given ‘strike’ price, usually a higher price than where the stock is currently trading. If the stock reaches that price before the expiration date the option buyer has the right to purchase your shares at the agreed-to price. Now if the stock continues up beyond the strike price before expiration, you have still benefited by the move in the stock between where it was when you sold the option contract and the price at which the option buyer bought the right to purchase the shares from you. You also, as the option seller, get to keep the option premium that the buyer paid you.

This doesn’t sound very risky does it? The answer is that it is not risky. There are, however, two potential downsides to this scenario if you are selling options. One is that you do not participate in any upward move in the stock above the strike price, at which you sold the right to purchase your shares. For example if you sold the option buyer the right to buy your shares at $100 per share when the stock was trading at $90 per share, if the stock is trading at $120 per share by expiration you must sell your shares at $100 (but you have still profited from the move between $90 and $100).

The other potential downside for you as the seller of the option is that the stock price may fall. Between now and the expiration date the stock may very well be trading lower than where it was priced when you sold the option. But in this case you’re still better off than if you had simply held onto your shares rather than selling the option, as again, remember that with options selling you get to keep the premium amount that the buyer paid you, and you get to keep your shares as the right to buy them at the now far-off strike price is worthless. You have a paper loss on the shares that you own, but your cost basis for the shares is slightly lower due to the premium amount paid by the buyer, that you get to keep.

I hope I’ve shown that there is more to options trading than just taking a gamble. The fact is that many savvy investors use options selling to create an income from their existing portfolio by selling, aka writing options against shares that they already own. As you get stock options explained to you further be sure and paper trade them for a while before actually committing any real money. The options market moves very quickly and the relationship between option premium prices than that of the underlying stock is not always clear cut.