Stock options can be confusing to many investors because they can be used to make bets on a wide variety of market outcomes. They have been marketed as portfolio insurance, a way to turbocharge returns, or a way to make money no matter which way the stock market moves.
In Part 1 of this post, I explained how stock options work and how they are valued. In Part 2 of this post, I will describe some common stock option strategies.
Stock Option Strategy #1: Buy Calls or Puts to Make Leveraged Bets
This is the most straightforward bet using stock options. For example, consider a scenario where you purchase a call option to buy Apple stock (current price: $132) for $135 by March 17, 2017. The price of this option is $1.00 per share. If AAPL is trading at $150 on March 17, 2017, I could exercise my right to purchase 1 share of Apple for $135, and then immediately sell it at $150. Taking into account my original option purchase price of $1, I would have made $14. However, if Apple is less than $135 on March 17, 2017, I would choose to let the option expire worthless, because it would be cheaper to buy the stock on the open market than by exercising my option. I would have lost only $1.
Notice that for only $1 per share, you are able to make 5x, 10x, or even 25x your money. This would not be possible if you simply purchased Apple stock for the regular price of $131.53. Even better, if the stock falls significantly, you will have lost less money with the stock option than if you had purchased the stock outright. Unfortunately, if the stock ends up trading at $135 on the expiration date, you will lose your entire option value, but would have made money if you bought the underlying stock.
Stock Option Strategy #2: Covered Calls Or Buying Puts As Portfolio Insurance
Let’s say you already own 1 share of Apple stock. You can write (sell) 1 call option and receive $1. If Apple rises, you will have to sell your stock to the call option buyer for $135. That’s OK, because you made money on the stock, and got the $1 when you sold the option. If Apple’s stock falls, you get to keep the $1, since the option buyer will not exercise the option. Even though the stock fell, you are better off than if you had not written the call option. It’s a win-win, right?
The problem is that you are capping your upside, while only partially limiting your downside risk. If Apple rises to $150, the option will be exercised, and you are forced to sell it for only $135. You missed out on $15/share of upside because you sold the option.
Another way to use stock options as portfolio insurance is to buy puts. This is done by owning a stock and buying a put option with a strike price below the current stock price. You have now bought insurance against a steep decline in the stock. If the stock drops below the strike price, you can exercise your put option and sell your shares at a higher price than its current price. If the stock price goes up, than your insurance (put option) is worthless, but it’s fine because the stock you own is rising.
The worst-case scenario when buying puts as portfolio insurance is if the stock doesn’t move or falls slightly. If the stock falls, but remains above the strike price, then you have lost money both on your stock investment and your put option.
Stock Option Strategy #3: Make Money in Any (Volatile) Market with Straddles
When you purchase a call option and a put option simultaneously, this is called a straddle. In its simplest form, both the call and the put would have the same strike price. If the stock were to move significantly in either direction, one option will expire worthless, but the other will be valuable, hopefully overcoming the loss on the other option. This enables you to make money whether the market goes up or down. However, this requires a volatile market where the stock moves a lot. If the stock is at the same price as the strike price at expiration, both options will expire worthless. Remember that the stock options are valued based on the assumed volatility of the stock, so you will likely only make money if the stock is more volatile than is expected when you purchased the options.
Stock options can be used to bet on a wide variety of market outcomes. What do you think? Have you ever tried any of these options strategies?