In general, derivatives are not suitable for most investors. Many derivatives strategies involve unlimited or otherwise significant risk. Even when the maximum loss is limited to the premium, the investor can still lose 100% of that premium in a relatively short time.
That said, some option strategies can be appropriate for conservative and risk-averse investors when they’re used to reduce risk or generate modest income from an existing stock position.
We’ll break down derivative suitability by grouping strategies into these categories:
When an investor goes long a call or long a put as their only option strategy, they’re typically seeking growth (capital gains/appreciation). Growth means buying at a lower price and selling at a higher price.
Because long options often rely on short-term price moves, they’re commonly described as speculative.
Here’s how a long call can produce a capital gain:
An investor purchases 3 long XYZ Sep 80 calls at $5 when the market price is $79. The market price rises to $120, the contracts are exercised, and the shares are liquidated in the market.
Can you figure out the overall gain or loss?
Answer = $10,500 gain
| Action | Result |
|---|---|
| Buy calls | -$1,500 ($500 x 3 contracts) |
| Exercise calls | -$24,000 ($80 x 300 shares) |
| Liquidate shares | +$36,000 ($120 x 300 shares) |
| Total | +$10,500 |
The investor went long 3 call options, giving them the right to purchase 300 shares at $80 per share. The cost of each contract was $5 per share. The market price increased to $120, resulting in the options gaining $40 of intrinsic value (in the money). The exercise allowed 300 shares to be purchased at $80. Those shares were then liquidated at the $120 market price, resulting in a $40 per share gain. The $40 gain on the stock is offset by the $5 premium cost, ending with an overall $35 per share gain. $35 gain multiplied by 300 shares results in an overall $10,500 gain.
In that example, the investor needed the market price to rise above the strike price for the strategy to work (long calls are bullish). If the market price stayed below $80, the investor would lose the entire $1,500 premium.
Even though the maximum loss on a long option is limited to the premium, losing 100% of the premium over a short period is still substantial risk. For that reason, speculative long call strategies are generally only suitable for aggressive investors with high risk tolerances.
Now let’s see how a long put can produce growth:
An investor goes long 2 MNO Feb 110 puts at $3 when the market price is $114. The market price declines to $85, the investor purchases 200 shares at the market price, and exercises the option.
What is the overall gain or loss?
Answer = $4,400 gain
| Action | Result |
|---|---|
| Buy puts | -$600 ($300 x 2 contracts) |
| Buy shares | -$17,000 ($85 x 200 shares) |
| Exercise put | +$22,000 ($110 x 200 shares) |
| Total | +$4,400 |
The investor went long 2 put options, giving them the right to sell 200 shares at $110 per share. The cost of each contract was $3 per share. The market price declined to $85, resulting in the options gaining $25 of intrinsic value (in the money). The investor purchases 200 shares at $85 per share, then exercises their right to sell those shares at $110. The end result is a $25 per share gain. The $25 gain on the stock is offset by the $3 premium cost, ending with an overall $22 per share gain. $22 gain multiplied by 200 shares results in an overall $4,400 gain.
In that example, the investor needed the market price to fall below the strike price for the strategy to work (long puts are bearish). If the market price stayed above $110, the investor would lose the entire $600 premium.
So, even with a defined maximum loss, long options can still be inappropriate for conservative investors because the premium can be lost in full.
Let’s summarize the suitability of long option strategies:
When an investor goes short a call or short a put as their only option strategy, they’re typically seeking income. These strategies are also considered speculative.
In this section, assume the options are uncovered (naked).
When an investor sells an option, they receive the premium immediately. That immediate premium is the main appeal of selling options.
The tradeoff is risk:
Most income-focused investors look to lower-risk income securities like bonds and preferred stock. Uncovered option writing doesn’t fit that risk profile. As a result, selling uncovered options is generally only suitable for aggressive investors seeking income who can tolerate very high risk.
Let’s summarize the suitability of short naked option strategies:
Unlike the speculative strategies above, hedging strategies are designed to reduce risk in a stock position. Two common hedging strategies are:
These strategies work much like insurance:
Because options expire (often within 9 months or less), repeatedly paying premiums over long periods can reduce overall returns. Still, for an investor who’s concerned about a large loss in a stock position, the premium may be worth the protection.
Index options can also hedge an entire portfolio, including mutual funds. For example, a fund manager of a large-cap stock fund could purchase S&P 500 puts to protect against a bear market. If the market declines, losses in the portfolio may be offset by gains in the put position.
Ultimately, the suitability of a hedging strategy depends on the underlying position it’s protecting. The premium reduces profits, but it can also prevent much larger losses.
Let’s summarize the suitability of hedging strategies:
Income strategies involve selling an option against a stock position. Two common income strategies are:
Covered calls and covered puts are most appropriate when the investor has a long-term view on the stock but expects the market to be flat in the short term.
For example, assume an investor owns 100 shares at $75. They expect the stock to rise over the next several years, but they don’t believe it will rise above $80 over the next 9 months. To generate additional return, they sell an 80 call against the stock.
Selling the call provides immediate premium income. The cost is that the investor gives up additional upside above the strike price. If the stock rises well above $80, the investor faces opportunity cost (risk).
Continuing the example, assume the stock rises to $125:
That missed upside is the main risk created by the covered call. Importantly, it’s not a loss of principal from the option itself - the investor still profits if the call is exercised.
Also notice how the premium can reduce downside risk. If the stock falls to $0, the short 80 call expires worthless and the investor keeps the premium. That premium offsets part of the stock loss. For example:
Because a covered call generally reduces risk (aside from opportunity risk), it can be appropriate for many investors as long as the underlying stock position is suitable. The stock still carries its own risks, including systematic and non-systematic risk.
Let’s summarize the suitability of a covered call:
A covered put, by contrast, is very risky. The main reason is the short stock position, which has unlimited risk.
For example, assume an investor is short 100 shares at $30 and goes short a 25 put:
However, if the market price rises, the investor can lose unlimited amounts of money. The put expires if the market price stays above $25, and the only “protection” is the premium received.
Also be careful with the name covered put - it can be misleading. The put’s risk (which shows up when the market falls) is offset by gains on the short stock. The short stock position is the primary source of risk in the strategy.
Let’s summarize the suitability of a covered put:
As we discussed in the previous chapter, futures and forwards are connected to commodity prices.
Futures contracts are standardized and exchange traded, allowing any investor interested in commodities to trade these contracts. Similar to options, futures investors can use them to hedge against price fluctuations. For example, Southwest Airlines went long oil futures in the late 1990s and early 2000s to hedge against rising oil prices. Investors can also use futures contracts to speculate (bet) on prices of commodities rising or falling. If their bet is right, they profit (and vice versa).
Forward contracts are customized and non-traded, making them only suitable for those actually planning on buying or selling the commodity. In most circumstances, forwards are used for hedging purposes. Here’s the example we discussed in the previous chapter:
A corn farmer projects their harvest to be 2.5 metric tons and they intend to deliver the corn to a cereal distributor. Both the farmer and the distributor are concerned about price fluctuations. If there’s an oversupply of corn due to favorable weather conditions, it’s possible the price of corn falls, which would negatively impact the farmer. If there’s a shortage of corn, it’s possible the price of corn rises, which would negatively impact the distributor.
To hedge themselves against the risk of price fluctuations prior to harvest, the two parties could enter into a forward contract. It would be non-standardized to fit the situation, allowing a custom amount of corn to be delivered at a custom date in the future. By locking in the details of the transaction now, both sides obtain protection against adverse price movements.
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