Suitability
In general, options are not suitable for most investors. Think about it - how many strategies have we covered that involve unlimited or significant risk? Even if the maximum loss is only the premium, that’s still risky! What if you learned about an investment that costs a few hundred dollars but has a good chance of expiring worthless after a few months? Regardless, we’ll cover a few suitable strategies for conservative and risk-averse investors.
We’ll break down the suitability of options by categorizing them into types of strategies:
- Long options
- Short options
- Hedging strategies
- Income strategies
- Straddles
- Spreads
Long options
When an investor goes long a call or long a put as their sole option strategy, they’re seeking growth (a.k.a. capital gains, appreciation). Growth occurs when an investor buys a security at a low price and sells it at a higher price. In many instances, these strategies are referred to as speculative.
Let’s demonstrate how these strategies can result in 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 the previous example, the investor bet on the market rising (long calls are bullish), and their bet paid off. If the market price stayed below $80, the option would’ve expired worthless, resulting in an overall loss equal to the $1,500 premium. Although a long option’s maximum loss is only the premium, it’s still risky. Think about it - what if you bought an investment for $1,500 today, and there was a decent possibility you could lose it all within just a few months? Therefore, speculative long call strategies are only suitable for aggressive investors with high risk tolerances.
Let’s now explore how a long put strategy could result in 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.
In the previous example, the investor bet on the market declining (long puts are bearish), and their bet paid off. If the market price stayed above $110, the option would’ve expired worthless, resulting in an overall loss equal to the $600 premium. Although a long option’s maximum loss is only the premium, it’s still risky. Think about it - what if you bought an investment for $600 today, and there was a decent possibility you could lose it all within just a few months? Therefore, speculative long put strategies are only suitable for aggressive investors with high risk tolerances.
Let’s summarize the suitability of long option strategies:
- Investment objective: speculative growth
- Suitable for: aggressive investors
- Risk tolerance: high
Short options
When an investor goes short a call or short a put as their sole option strategy, they’re seeking income. Similar to long options, these strategies are considered speculative. However, these are much riskier when uncovered (naked), which is our assumption in this section.
When a short option is traded, the investor immediately receives a premium. Investors seeking income obtain their goal immediately when they sell the call or put. That’s the benefit of selling options - instant income.
However, the income comes with a cost - risk. Short naked calls are subject to unlimited risk, while short naked puts are subject to significant risk (equal to the strike price minus the premium, times the number of shares involved). Most income-based strategies involve safer securities like bonds and preferred stock, but that’s not the case here. Only the most aggressive investors seeking income that are tolerant of significant risk should consider selling uncovered options.
Let’s summarize the suitability of short naked option strategies:
- Investment objective: speculative income
- Suitable for: aggressive investors
- Risk tolerance: very high
Hedging strategies
Unlike the speculative strategies we’ve discussed, hedging strategies typically reduce risk exposure. There are two hedging strategies to be aware of:
- Long stock with long put
- Short stock with long call
While long options can result in losing the premium, these strategies act similarly to insurance. The investor pays a premium in exchange for considerable risk reductions. Pairing certain long options with stock positions is suitable for investors concerned about experiencing capital losses on their stock. Options don’t last forever (most last 9 months or less), so the cost of paying option premiums over long periods can eat away at an investor’s profitability.
While the most common hedging strategies involve stock positions, investors also use non-equity options for protection. As a reminder, 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 is dependent on the position it covers. While the cost of the premium may reduce profits, it might save the investor from significant losses.
Let’s summarize the suitability of hedging strategies:
- Investment objective: protection
- Suitable for: depends on the position it covers
- Risk tolerance: varies
Income strategies
Income strategies involve an investor selling an option against a stock position. There are two primary income strategies:
- Long stock with short call (covered call)
- Short stock with short put (covered put)
Covered calls and puts are suitable for investors with long-term stock outlooks but with expectations for a short-term flat market. For example, assume an investor maintains the following positions:
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
This is a suitable strategy if the investor expects the stock price to rise over the next several years, but doesn’t believe it will rise above $80 before the option expires. The receipt of the premium immediately provides income to the investor. However, it comes at a cost - the investor cannot gain anything additional on the stock if it rises above the strike price ($80 in our example). The investor faces opportunity cost (risk) if the stock price rises significantly above the strike price, the primary risk the short call exposes the investor to.
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
Returning to our example, let’s assume the stock price rises to $125. If the investor hadn’t sold the call, they would’ve gained $50 per share. With the short call in place, the investor is forced to sell the stock at $80 when assigned, resulting in a $5 per share gain (plus the call premium). This is a good example of opportunity risk.
Missing out on potential return is the primary risk the short call presents to covered call investors, which isn’t significant. The investor still profits if the call is exercised. Therefore, covered call positions can be recommended to almost any investor that is already long the stock. Obviously, the stock subjects the investor to its own set of risks (systematic and non-systematic). Regardless, the call reduces overall risk for the position by allowing the investor to keep the premium.
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
To demonstrate this, let’s assume the stock price falls to $0 in our example. The short 80 call is “out of the money” and expires worthless, but the investor keeps the premium. The premium offsets the overall loss on the stock, essentially “softening the blow” the investor takes from the significant stock loss. If the investor hadn’t sold the call, they would lose $7,500 ($75 x 100 shares). The call premium partially offsets the stock loss, reducing the overall loss to $7,100 ($7,500 stock loss - $400 premium).
Selling calls against already-maintained stock positions is suitable for investors of all backgrounds, including older conservative (risk-averse) investors. If the investor already owns the stock, adding the short call only reduces overall risk (other than opportunity risk).
Let’s summarize the suitability of a covered call:
- Investment objective: income in flat/neutral markets
- Suitable for: virtually all investors if the stock position is suitable
- Risk tolerance: depends on stock position
On the other hand, a covered put is a very risky position due to the short stock position, which is not protected. For example, let’s 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 minimally, the investor keeps the $5 premium and could make gains on the short position 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.
On the other hand, the investor can lose unlimited amounts if the market price rises. The put expires if the market price stays above $25; the only protection it provides is the premium received. Regardless, the unlimited risk potential is too much risk for most investors. Be mindful of how the name of the position - covered put - can be misleading. The put’s risk, which manifests when the market price falls, is offset by the gains of the short stock position. But, the risk presented by the short stock position (when the market rises) is not covered.
Let’s summarize the suitability of a covered put:
- Investment objective: income in flat/neutral markets
- Suitable for: aggressive investors
- Risk tolerance: very high
Straddles
Straddles are aggressive speculative strategies betting on market volatility. These are the two straddle strategies to be aware of:
- Long straddles (long call with long put)
- Short straddles (short call with short put)
Long straddle investors seek capital appreciation when the market price rises or falls. The long call is exercised if the market price rises, allowing a purchase of shares at the call’s strike price and a sale of those shares at the higher market price. The long put is exercised if the market price falls, allowing a purchase of shares at the market price and a sale of those shares at the put’s strike price.
If the market remains flat at the common strike price, the investor realizes a loss equal to both premiums. This could result in considerable short-term losses, especially if numerous straddles are purchased. The potential loss of two premiums makes long straddles only suitable for aggressive investors.
Let’s summarize the suitability of a long straddle:
- Investment objective: speculative growth in volatile markets
- Suitable for: aggressive investors
- Risk tolerance: high
Short straddle investors obtain immediate income when both options are sold. In the best-case scenario, the underlying stock’s market price stays flat (at the common strike price) and both options expire. If the market does fluctuate, the investor remains profitable as long as the market price doesn’t stray too far away from the strike.
While the premiums could provide substantial instant income, this strategy has unlimited risk potential. If the market price rises substantially, the short (uncovered) call subjects the investor to ever-increasing losses. Although the short put’s loss potential is limited, losses can be substantial if the market price falls drastically. Due to the risk involved, only the most aggressive investors seeking income should consider selling straddles.
Let’s summarize the suitability of a short straddle:
- Investment objective: speculative income in flat markets
- Suitable for: aggressive investors
- Risk tolerance: very high
Spreads
Spreads involve the simultaneous purchase and sale of an option. The two spread strategies to be aware of are:
- Call spreads (long call with short call)
- Put spreads (long put with short put)
As you learned previously, there are several spread types. Spreads can be considered income or growth-oriented, bullish or bearish, horizontal (calendar/time), vertical (price), or diagonal. Additionally, most spreads involve limited gains and losses. Bottom line - there’s a lot of variety with option spread strategies.
The best way to determine the investment objective of a spread is by identifying the dominant leg. For example, assume the long call is the dominant leg in a call spread. If so, the investor is likely seeking capital appreciation (similar to the objective of long call options that we discussed above). Or, if the short put is the dominant leg in a put spread, the investor is likely seeking income (similar to the objective of short put options that we discussed above). If you need a refresher on how to do so, revisit the call spread and put spread chapters.
Although spread strategy gain and loss potential tend to be limited, these are still short-term speculative strategies involving high levels of risk. Depending on the market’s movement, the investor may reach their maximum loss within a short period. Therefore, these are strategies that are primarily reserved for aggressive investors.
Let’s summarize the suitability of a spread:
- Investment objective: depends on the dominant leg
- Suitable for: aggressive investors
- Risk tolerance: moderate to high
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