The Purpose of Options - Hedging
The Camry example from our first article in the series was an example of hedging. To catch you up, I came to an agreement with the owner of a Toyota Camry that I’d buy the right to purchase the Camry for $3,000 in the next 12 months, in exchange for $500. The owner of the car got $500 upfront but has to be ready to sell me the car for $3,000 at any time in the next 12 months, regardless of what happens to the Camry market.
I was hedging against two things: the market value of Toyota Camrys rising in the next 12 months, and my current car breaking down in the next 12 months.
This is the most common purpose for stock options. An investor with a large position in a stock might want to hold the stock in the long-term, but is preparing for a period of increased volatility and underperformance, and wants to hedge against their expected losses. Instead of selling their position and having to pay taxes on the gains, and risk having to buy back in at a higher price, most investors choose to use options to hedge this position as a sort of portfolio insurance.
Let’s say you hold 1,000 shares of XYZ. There are rumors that XYZ’s next earnings report is going to be weak. You think XYZ is a great long-term investment and want to continue to hold your shares, but want to avoid the short-term losses, so what do you do?
You can buy put options in a quantity proportional to your shares holdings. In this example, you’d buy 10 put options (each contract represents 100 shares). If the stock drops after the earnings report, your puts will earn roughly an equal amount to the losses on your shares position.
Each options contract in the US stock market controls 100 shares, generally, options require little buying power. Let’s take an example from the options market:
At the time of writing, we can buy an Oct 16th $301 call on SPY for $380. What does this mean? For $380 in premium, we can purchase the right to buy 100 shares of SPY at a price of $301 until October 16th, 2019, which is 33 days away.
We’re essentially controlling $30,100 in SPY buying power for $380. That’s almost 100:1 leverage! Much better than stock or futures markets.
Of course, this comes with the caveat of paying a premium to the writer of the option. Additionally, we have to get our timing right (the stock has to move to our desired price before the option’s expiration), and to a degree, volatility (if we have to pay a lot of premium to establish a position, that makes it so the stock has to move further in our direction for our position to be profitable).
Ways to Profit from Options
The various strike prices, expirations, and different contracts (puts and calls) offered by the options market allows you to create sophisticated strategies that allow you to profit from a diverse set of scenarios.
Using options spreads, you can profit from more than just price going in your favor:
Price Change or Lack Thereof
Of course, you can profit from getting price direction right, but there are also options strategies that allow you to profit from the price not changing, or being able to forecast that the stock will stay within a given range.
A market-neutral spread like the iron condor is profitable when the price stays inside of a given range for the duration of the options’ life. An iron condor is created by simultaneously purchasing and writing different options to create its payoff.
We’ll touch more on these strategies in the next part of the series.
Volatility expansion or contraction
You can profit from the expansion or contraction of volatility, even if you’re not betting on the price directionally. Each option spread has its own vega or its level of sensitivity to volatility.
Your exposure to volatility depends on if you’re a net holder or writer of options.
If you buy a call or put outright, you’re 100% net long volatility, because you’re paying a premium, while if you write a put or call outright, you’re 100% net short volatility, because you’re paying a premium.
Option spreads typically have a mix of written and held options, so your spread’s sensitivity to volatility will vary based on that concentration.
There are three key components to an option’s value: the strike price, the expiration date, and the premium paid.
To put things in real terms, which contract would you rather own, the right to buy a house for 12 months, or one month? As an option gets closer, it’s value decays. This concept is known as time decay or theta.
Time decay plays in favor of options writers and against option buyers.
There is a school of thought among some options traders that you should only focus on writing options because of this phenomenon. They definitely have a point, because most options expire out-of-the-money, allowing the option writer to collect the premium and pay nothing out to the option holder.
The main purposes of options for most market participants are hedging, increased leverage, and the diverse position construction not offered by stock or futures markets, like the ability to profit from changes in volatility, market neutrality, and time decay.Guide to Options Trading: Part One