Options are a type of financial instrument, (also called derivatives) that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price on or before a specified date. They can be used in an almost unlimited way in investment portfolios, let’s take a look a few ways they can be used:
- Hedging: Think insurance for your investment portfolio. Options can be used to hedge against potential losses in an underlying asset, helping to limit downside risk. For example, an investor who has a concentrated position in one particular stock, maybe the investor works at a company and has received a significant amount of shares or stock options as part of their compensation. This investor could purchase a put option to insure their concentrated stock position from losing money.
A form of insurance. An additional benefit: If the stock doesn’t go down, and the insurance isn’t “used,” then up to $3,000 of the cost of the insurance can be written-off against your ordinary income for tax purposes.
- Income Generation: Options can also be used to generate income through selling options premium. An option premium is the price that the buyer of an option pays to the seller for the right to buy or sell the underlying asset. The seller of an option is often referred to as the writer. By selling options, investors can collect the premium, which can provide a steady stream of income for the investor.
For example, an investor can sell a call option on a stock they own, collecting the premium and potentially earning income without having to sell their stock.
- Getting Paid to Wait: To be a successful investor its important to have a systematic and rational way of building an investment portfolio. When purchasing stock, bonds, commodities, ETF’s, etc., it’s important to have a plan in place as to when you want to purchase a particular investment and at what price. Rather than use a limit order to purchase your next investment, by using options you can get paid to wait until a particular investment reaches your price target.
What’s great about this, if the price is never reached, you keep the income and can roll into another option for additional option income.
- Diversification: One of the main benefits of options is their ability to diversify an investment portfolio. Diversification is important in investing because it helps to reduce the overall risk of a portfolio by spreading investments across a variety of assets. By using options, investors can gain exposure to different markets and industries, helping to reduce the impact of market volatility on their portfolio.
- Leverage and Potential High Returns: Another benefit of options is their ability to provide leverage. Leverage refers to the ability to control a large amount of assets with a relatively small investment. This is because options are priced based on the underlying asset and are therefore much less expensive than buying the underlying asset outright. For example, an investor can use options to control 100 shares of a stock for a fraction of the cost of buying the stock outright.
This can potentially provide a higher return on investment, but it can also increase the risk of loss.
- Flexibility and Risk Management: Options can be customized to suit a wide range of investment strategies and goals. For example, investors can choose the expiration date of an option to align with their investment timeline. They can also choose the strike price of an option, which is the price at which the underlying asset can be bought or sold, to suit their investment goals. This flexibility allows investors to tailor their options strategy to their individual investment objectives.
Options can be used to manage risk by setting specific price targets or expiration dates. For example, an investor can use options to set a price target for a stock they own by selling a call option at that price. If the stock reaches the target price, the investor will sell the stock and collect the profit. Alternatively, an investor can use options to set an expiration date for a stock they own by selling a call option that expires on that date.
If the stock does not reach the target price by the expiration date, the investor will still retain ownership of the stock.
Options are not for everyone and understanding the risks and potential benefits are important before using options. However, for certain individuals and under certain circumstances, options can be a great tool. The more tools in your proverbial toolbelt the better.
If your only tool is a hammer, then every problem looks like a nail.
-Paul R. Rossi, CFA