Two basic trading strategies for Options – Speculation & Insurance/Hedging.
Remember the characteristics of an option. Buying a call or put option contract over a stock, gives you the right to buy (call) or sell (put) 100 shares of the underlying stock, at a certain price, on or before a set date in the future.
Speculation
So if you believe that a stock will rise in the future, instead of purchasing the stock, you can purchase a call option (I prefer long term options for this strategy).
Why do this?
Let’s walk through an example.
Say AAPL is trading at $100 and I believe that this stock will be trading at $150 in 12 months time. To purchase the underlying stock, I would have to pay $100 per share and take the risk of a fluctuating stock price. Purchasing 100 shares will cost $10,000.
12 Month 140 strike Call options are trading at $2 per share. I can purchase 1 of these for $200 (one options contract refers to 100 shares). This is significantly less capital than $10,000.
My maximum possible loss for this trade is $200 (plus commissions). To make a profit AAPL will need to trade over $142 (140 strike + $2 option contract cost per share).
If I purchased 100 shares of the underlying, at a cost of $10,000, my maximum loss is could be $10,000. I also have to manage the trade, in case the shares dip for some reason.
There are pro’s and con’s, of using Options to speculate. I like the known level of risk & less need to manage the trade.
Insurance / Hedging
Options can be used to protect profits in the case of an unexpected market reversal.
Let’s use the example of AAPL again.
I have 100 AAPl shares, currently trading at $100, I purchased these at $80, meaning I have a $20 per share profit.
I believe that AAPL will continue to rise and so I don’t want to sell the shares and take my profits. I could hedge or insure my position, by buying a 12 month $100 Put option. This gives me the right to sell my shares at $100 at any time for the next 12 months time. The Put option will cost whatever the market is valuing those options at the time. If the Put option costs $4 per share, I have “locked-in” a profit of $16 per share (my $20 dollar profit per share, less the $4 per share cost of the option).
If AAPL falls to $90 before expiry, my Put option still gives me the right to sell my shares at $100, and I still make a profit of $16 on my original $80 purchase prices.
If AAPL rises to $140, I will let the Put option expiry un-exercised as I can sell the shares on the open market for $140, rather than through the option price of $100.
So for a $4 per share expenditure, I have protected a profit of $16 per share. When the Put option expires I can purchase another one (similar to car insurance), close out my position, or do nothing.