In general, options are not suitable for most investors. Many option strategies involve unlimited risk or the possibility of losing a large amount in a short time. Even when the maximum loss is limited to the premium, that premium can still be lost entirely if the option expires worthless.
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 on an existing position.
We can organize option suitability by strategy type:
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 can expire worthless, these strategies are often described as speculative.
Let’s see how a long call can produce capital gains:
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 determine 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. XYZ’s market price increased to $120, and the options went $40 “in the money” (gained $40 of intrinsic value). The exercise allowed 300 XYZ 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 is offset by the $5 premium cost, ending with an overall $35 per share gain. $35 gain per share multiplied by 300 shares results in an overall $10,500 gain.
In this example, the investor needed the market price to rise (long calls are bullish). If the market price had stayed below $80, the option would’ve expired worthless and the investor would’ve lost the entire $1,500 premium.
So even though a long option’s maximum loss is limited to the premium, the risk is still meaningful: you can lose 100% of the amount invested in a relatively short time. For that reason, speculative long call strategies are generally suitable only 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 MNO 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” by $25). The investor purchases MNO shares in the market at $85, then exercises their right to sell the MNO shares at $110, resulting in a $25 per share gain. The $25 gain is offset by the $3 premium cost, ending with an overall $22 per share gain. The $22 gain multiplied by 200 shares results in an overall $4,400 gain.
Here, the investor needed the market price to fall (long puts are bearish). If the market price had stayed above $110, the option would’ve expired worthless and the investor would’ve lost the $600 premium.
Again, the maximum loss is limited to the premium, but the premium can be lost entirely. That’s why speculative long put strategies are generally suitable only for aggressive investors with high risk tolerances.
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. Like long options, these strategies are 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:
Many income-focused investors use lower-risk income securities like bonds and preferred stock. Uncovered option writing doesn’t fit that profile. Only the most aggressive investors seeking income, and who can tolerate substantial losses, should consider selling uncovered options.
Let’s summarize the suitability of short naked option strategies:
Unlike the speculative strategies above, hedging strategies are typically used to reduce risk exposure. Two key hedging strategies are:
These strategies work like insurance: the investor pays a premium to reduce potential losses. They’re often used by investors who want to limit capital losses on an existing stock position.
One practical limitation is time. Options expire (often within 9 months or less), so repeatedly paying premiums over long periods can reduce overall profitability.
While stock-based hedges are the most common, investors also use non-equity options for protection. These are the four primary non-equity option types:
Index options can protect entire portfolios, including mutual fund portfolios. For example, a large-cap stock fund manager could purchase S&P 500 puts to protect against a bear market. If the market declined, the portfolio’s losses would be offset by the put’s returns. The same strategy could be utilized with VIX options. Remember, the VIX is known as the “fear gauge” and is correlated with market declines. Going long a VIX call would provide a return if volatile markets resulted in a general market decline.
Foreign currency options could be used as a hedge if an investor had exposure to foreign securities. For example, an investor concerned about the Japanese Yen weakening could go long a Yen put. If the currency lost value, the put’s returns would offset losses due to currency exchange risk.
Investors with bond portfolios are always concerned about interest rate risk. If interest rates rise, the market values of bonds decline. If the increase in interest rates is substantial, losses could be significant. To offset this risk, an investor managing a portfolio of bonds could go long a yield-based call. The option would gain intrinsic value and offset bond losses as interest rates and yields rise.
Ultimately, the suitability of a hedging strategy depends on the position it covers. The premium may reduce profits, but it can also prevent large losses.
Let’s summarize the suitability of hedging strategies:
Income strategies involve selling an option against a stock position. Two primary income strategies are:
Covered calls and covered puts are often used by investors with a long-term view on the stock, but who expect the stock to be flat (or move only modestly) in the short term.
For example, assume an investor maintains the following positions:
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
This strategy fits when the investor expects ABC to rise over the next several years, but doesn’t expect it to rise above $80 before the option expires. The premium provides immediate income.
The cost is that gains above the strike price are given up. That tradeoff is the covered call’s main risk: opportunity cost (risk).
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
Continuing the example, assume the stock price rises to $125. Without the short call, the investor would’ve gained $50 per share. With the short call, assignment forces the investor to sell at $80, producing only a $5 per share stock gain (plus the call premium). That difference illustrates opportunity risk.
Opportunity risk is usually considered a limited risk: the investor can still profit if the call is exercised. For that reason, covered calls can be recommended to many investors as long as the underlying stock position is suitable. The stock still carries its own risks (systematic and non-systematic).
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
A covered call can also reduce the position’s downside slightly because the investor keeps the premium. If ABC fell to $0, the short 80 call would expire worthless and the investor would keep the $400 premium. Without the call, the stock loss would be $7,500 ($75 x 100 shares). With the premium, the net loss becomes $7,100 ($7,500 stock loss - $400 premium).
Selling calls against an existing stock position is suitable for investors of many backgrounds, including older conservative (risk-averse) investors. If the investor already owns the stock, adding the short call generally reduces overall risk (other than opportunity risk).
Let’s summarize the suitability of a covered call:
A covered put is much riskier because it includes a short stock position, and that short stock risk is not protected.
For example, assume an investor maintains the following position:
Short 100 XYZ shares at $30 Short 1 XYZ 25 put at $5
If the market price stays flat or declines slightly, the investor keeps the $5 premium and can profit on the short stock down to $25. If the market price falls below $25, the put goes “in the money” and will be assigned, requiring the investor to buy back the stock at $25 (closing the short stock position). Like a covered call, the short put caps the stock’s gain potential.
The major problem is the upside risk in the short stock. If the market price rises, the investor can lose unlimited amounts. If the market price stays above $25, the put expires worthless; the only protection it provides is the premium received.
Be careful with the name covered put. The put’s risk (which shows up when the market price falls) is offset by gains on the short stock. But the short stock’s risk (when the market rises) is not covered.
Let’s summarize the suitability of a covered put:
Straddles are aggressive speculative strategies that bet on volatility. Two straddle strategies to know are:
Long straddle investors seek capital appreciation if the market price moves sharply up or down.
If the market stays flat at the common strike price, both options can expire worthless and the investor loses both premiums. Because the potential loss includes two premiums (and can add up quickly across multiple contracts), long straddles are generally suitable only for aggressive investors.
Let’s summarize the suitability of a long straddle:
Short straddle investors receive immediate income by selling both options. The best-case outcome is that the underlying stock’s market price stays near the common strike price and both options expire. If the market moves, the investor can still be profitable as long as the price doesn’t move too far away from the strike.
The premiums can be substantial, but the risk is substantial as well:
Because of this risk, only the most aggressive investors seeking income should consider selling straddles.
Let’s summarize the suitability of a short straddle:
Spreads involve the simultaneous purchase and sale of an option. Two spread strategies to know are:
There are several spread types. Spreads can be income- or growth-oriented, bullish or bearish, horizontal (calendar/time), vertical (price), or diagonal. Most spreads also have limited maximum gains and limited maximum losses.
A practical way to identify a spread’s objective is to find the dominant leg:
If you need a refresher on how to identify the dominant leg, revisit the call spread and put spread chapters.
Even though spreads often limit gains and losses, they’re still short-term speculative strategies. Depending on market movement, an investor can reach the maximum loss quickly. For that reason, spreads are primarily reserved for aggressive investors.
Let’s summarize the suitability of a spread:
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