Suppose that you own a stock that has done pretty well over the past few years, but you believe that new regulations could cause a short-term decline in price. Selling the stock would trigger a large capital gains expense when you’d really just be repurchasing the stock later. A better alternative might be to agree to sell the stock at a certain price to lock in profits and then pay the difference if it rises.
The agreement cited in the example above is a type of stock option known as a protective put option. Stock options like these provide traders with flexible tools designed to hedge against risk, increase leverage, and/or execute a number of other strategies to enhance risk-adjusted returns. In this article, we’ll take a look at what stock options are, as well as how, why, and when to use them.
Stock Options 101
Stock options provide buyers with the right, but not obligation, to buy or sell a stock at a certain price at or before a certain date. Conversely, stock option sellers have the obligation to buy or sell a stock at a certain price and date depending on the whims of the stock option buyer. Multiple stock options can also be combined in order to create complex and highly specific trading strategies.
Before getting into the various types of stock options, it’s helpful to learn some of the jargon that traders use when trading options. Every option has a strike price and an expiration date at its core. The strike price refers to the price at which the option is exercised (e.g. the price that the buyer pays for the stock), while the expiration date is the date at which an option contract expires and becomes worthless.
There are also two basic types of stock options known as call options and put options and traders can either be buyers or sellers of each type of option. Call options give the option buyer the right to buy the stock at a certain price at or before the expiration date and the option seller the obligation to sell, while put options give the option buyer the right to sell and the option seller the obligation to sell.
Stock options are usually quoted in option chains showing a variety of different strike prices and expiration dates for both call and put options, as seen in Figure 1 above showing the NASDAQ’s stock option table for Apple Inc. The table is divided into call options on the left and put options on the right for the same strike prices, with other important data points like bid, ask, and open interest.
Why Stock Options?
Stock options are useful because of their tremendous flexibility when executing on a trade thesis. For example, suppose that a trader believes that a stock will remain range-bound over the next six months based on a strong price channel. The trader could buy and sell the stock at the channels highs and lows over time, but a stock option strategy called the iron condor was designed specifically for that purpose.
On a more general level, there are many reasons for traders to use stock options:
- Risk Management – Stock option strategies, like the protected put, and be very useful in managing risks associated with existing stock positions or in hedging risks by gaining or reducing exposure to broad market indexes.
- Increased Leverage – Stock options provide a lot more leverage than plain vanilla stocks, particularly when looking at stock options that have strike prices distant from the current stock price (known as out-of-the-money).
- Specific Strategies – Stock option strategies exist for practically any anticipated stock price action (including price inaction!), making them ideally suited for capitalizing on exacting predictions.
In general, stock options provide traders with additional flexibility, acting as a complementary tool alongside traditional stock and other derivatives. There are almost always times in which stock options would be useful in simply providing a hedge against market risk or substituting for stock transactions to make a particular trade thesis pay off more handsomely in terms of risk-adjusted returns.
How to Trade Options
Stock options are complex financial derivatives, which means they are both highly risky and subject to additional regulation. Many brokerages require clients to apply for approval to trade options, certifying that they are experienced in the financial markets and are willing to assume the risks. Traders should also take education seriously and understand the positions they’re entering beforehand.
After gaining an understanding of how options work, traders must analyze both a stock and its options in order to identify an opportunity. Stock option prices are based on a number of different factors, including the underlying stock’s volatility and the time until expiration. These factors are represented by option greeks like delta, vega, theta, and gamma, signifying various factors influencing valuations.
Traders must also consider the many different strategies available before making the trade through their brokerage platform. While covered calls may be relatively straightforward in selling call options using an existing long stock position as the underlying stock, complex strategies can involve multiple types of options at different strike prices and expiration dates to achieve various objectives.
When traders are ready to sell, there are three possible outcomes for option buyers:
- Hold Until Maturity – The stock option buyer can hold the stock option until the contract expires and then exercise the option at the strike price.
- Trade the Option – The stock option buyer can sell the option itself to someone else before the expiration date at a profit or loss.
- Let it Expire – The stock option buyer can let the option expire if it’s worthless at the time of expiration based on the strike price.
When selling options, there are two different possibilities to exit the position:
- Covered Calls – The stock option seller owns the underlying stock, meaning the stock option buyer simply buys it from them.
- Uncovered Calls – The stock option seller doesn’t own the underlying stock, meaning they must buy the stock and provide it to the stock option buyer.
The Bottom Line
Stock options provide traders with a flexible tool to enhance risk-adjusted returns by hedging risks or leveraging returns. With their ability to profit in any market conditions, stock options also provide greater flexibility than vanilla stocks in capitalizing on certain situations that may be occurring – such as a stagnant stock that isn’t moving in any particular direction at all.