by Houghton and Atkeson 08/01/08
There are many reasons to trade options -- namely, to spend a little bit of money for the possibility to make BIG returns -- but we can boil them down to three main objectives:
* Hedging
* Collecting premium
* Betting on a stock, sector or market's direction
THE HEDGE EDGE
The vast majority of options trades are executed for the purpose of hedging -- that is, protecting the value of what you already own. Investors generally buy and hold stock, or what's known as "being long" stock, and one of the most-straightforward ways to protect the value of the stocks in an existing portfolio is to buy a put option.
If your stock declines in value, the put premium should rise and help limit any losses you may incur in the event of a pullback in the share price. If the stock appreciates, however, the option's loss in value is limited to the cost of the put.
The same is true for short-sellers (i.e., someone who borrows their broker's money to short stocks or options) who buy call options to cap their potentially unlimited loss in case their short trade goes against them.
A 'PREMIUM BLEND' OF INVESTING STRATEGIES
Collecting premium, or selling volatility, is another reason why people trade options. The more movement that's taking place in the markets and in individual stocks, the higher option premiums tend to go. And during less-volatile times, investors who want to enhance the value of stocks held long can sell covered calls.
A "covered call," which is also called "writing" covered calls, means "selling to open" a call -- using your long stock as a hedge -- to generate income while the stock value is remaining fairly steady. Although the stock may not be making great advances, you are simulating gains by creating them yourself through the short sale (and, therefore, premium collection) of a call option.
In this case, an investor sells calls at a higher strike price than the current value of the underlying stock. For example, if you hold shares of Apple (AAPL) at $150, to benefit from this strategy, you would sell AAPL calls with strike prices of $155 or above.
The hedge portion of this trade is to effectively lower the cost of your stock by collecting option premium. If your stock is not called away -- that is, the holder of the option (i.e., an individual who "bought to open" a call option with the same strike price of the option you sold) does not exercise the option -- because of appreciation through the strike price, it helps to juice up your portfolio returns.
Think of it this way: In this example, you are holding a profitable position in AAPL and enjoyed gains even when the stock was trading flat. It doesn't matter how you're making gains -- just as long as you're making them! Trading options can generate returns faster and more frequently than simply buying and holding the stock by itself.
However, there are risks to selling covered calls. First, the stock could drop way down and the premium you collect is peanuts relative to your loss in the equity. Or, if the stock rips up and through the strike price in the contract you sold, you could lose the stock and potential upside. Having the stock called away can also trigger unwanted tax consequences.
During the past 10 years, selling covered calls became very popular, as implied volatility was typically priced higher than actual volatility. In the past year, however, actual volatility levels have increased making this strategy less attractive.
