An Introduction to Options

Many people who are not that familiar with the world of equity options view these instruments as extremely risky and useful only for the most sophisticated of investors. Actually, options can be quite practical for the average investor, and can be used to reduce overall portfolio risk. Options are popular because they can be used in many ways, including:

1. Speculating
   
2. Hedging a position or an entire portfolio
   
3. Generating income on a stock (s) already owned, and/or lowering breakeven
   
4. Accumulating stock
   
5. Distributing stock

Speculation is a common use of equity options, and is probably why many of those unfamiliar with options typically associate them with risk. Option speculators are attracted by the large potential returns linked with buying options. In short, buying options allows one to achieve leverage, make money in up and down market conditions, and control a number of shares with a small capital commitment.

Options can also be used to hedge against positions already held in an equity portfolio. If you're concerned that the market may fall over the next several months, but don't want to sell the stocks in your portfolio, you can acquire "portfolio insurance" by purchasing index put options. For example, a portfolio heavily exposed to technology stocks can be hedged by purchasing put options on the Nasdaq 100 Index (NDX: sentiment, chart, options) . In the simplest terms, put options will rise in value when the underlying index falls in price. Therefore, some or all of the losses sustained due to the decline in value of the stocks in your portfolio are offset (or partially offset) by the increase in value of the purchased put option.

Another use of options is to generate income on stock positions already held, or to lower the breakeven on stock positions being purchased. This is done by selling an out-of-the-money call (this option has a strike price that is above the current stock price). When selling a call to open a position, you take on the obligation (if the buyer of the call exercises his right) to deliver the shares at a certain price (strike price) by a certain future date (expiration date). When selling options, you pocket the premium received from selling the option. When used in this manner, the owner of the stock sells calls because he thinks the stock will stagnate over the short term. The sold call generates income even if the stock fails to stage a rally.

Selling call options against a stock can also be implemented when one is looking to distribute the stock and raise a little extra cash in the process. Another way of looking at this is getting paid to place a limit order to sell the shares. Selling an in-the-money call option (the strike price is below the stock's current price) increases the likelihood of the option being called away (i.e., the call buyer exercise his right to take delivery of the shares at the strike price). In this case, the seller receives more protection on a downside move and gives up all upside potential in the shares. On the other hand, selling an out-of-the-money call against a held stock decreases the likelihood of the stock being called away. Thus, there is less protection against an adverse move in the stock, but the seller is allowed to capture some of the upside in the shares between the time the option was sold and its expiration date.

The last option strategy uses options to accumulate stock positions by selling puts to acquire a stock below market value. A put seller takes on the obligation to purchase the shares at a predetermined price (strike price) before or on a future date (expiration date). If by expiration the stock doesn't pull back to a level where the put buyer wants the put seller to purchase the stock, the put seller simply pockets the premium from the put sale and has no additional obligations. We call this "getting paid to wait." If the stock does pull back far enough and the put is exercised, the put seller must purchase the shares. In this scenario, and similar to the distribution discussion above, the put seller was paid to place a limit order to buy the stock. Furthermore,the put seller acquires the shares at a price below that in effect when the put was originally sold. Plus, he retains the premium from the put sale, which lowers his net cost to acquire the shares.

As you can see, options are extremely versatile instruments that can greatly enhance the performance or reduce the risk of an investment portfolio.