Options Basics- Some Options Strategies-Options as Insurance

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

Example: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.

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.