We have covered the basics of what options are and how options work so now let’s take a look at some simple strategies using options.
Options can be used as an insurance by locking in either a buy or sell price the investor protects himself against major price fluctuations.
Buy Put Option- Lock Sell Price
If an investor believes that the market is overvalued and will go down in the next year or so they can purchase a put option to lock in a sell price, when the price falls below the strike price the investor can sell the security at a higher price than current market prices and than repurchase them at a lower price if they wanted to. If your spread between the strike price and new purchase price are wide enough you could potentially make a gain on this, however the main purpose of this strategy is to provide downside protection.
Example:
You own 200 shares of ABC your cost was $12.50/stock for a total of $2500 the current price for ABC is $18.50, Although you like ABC you believe that the stock is overvalued and will go down over the next twelve months you purchase a put option for $2 with strike price of $15 expiring in twelve months your total cost for the purchase of the put option is $400. Twelve months later ABC is trading at $11 you exercise your option and receive $3000 for 200 ABC stock. Now you can choose to wait or repurchase the stock back at $11 for total of $2200.
Buy Call Option- Lock Purchase Price
Sometimes investors want to purchase a company but no sure if it is the right time or not so they purchase a Call option. By buying a call option you are locking in a potential buy price in the hopes that the price will rise in the future, if it doesn’t you just let the option expire.
Example:
You like ABC which is currently trading at $12.50, but you are not sure if it is low enough yet so you purchase a call option. You buy an ABC call option for $1.5 with a strike price of $14.00 expiring in twelve months. In twelve months if ABC is trading over $14 you can choose to exercise the option and purchase the stock at a lower price, if it is trading below $14 you simply let it expire and can purchase it at market price.
What I think
Both strategies involve market timing and one thing I have learned is that market timing almost never works, I believe that if you are a long-term buy and hold investor you should stick with the strategy and not involve yourself with options.
Options are complicated and potentially risky strategies.
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{ 2 comments… read them below or add one }
Options can be used as insurance, but watch out. They are tricky and can be very risky.
Options are great but most people just don’t know how to use them. As a defensive strategy I agree with, but just watch out if you get involved in complex options strategies. Most people just can’t execute them.