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 a meaningful amount of money - and there’s always a real chance the option expires worthless.
That said, some option strategies can be appropriate for conservative and risk-averse investors, especially when the option is used to reduce risk rather than to speculate.
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 occurs when an investor buys a security at a lower price and sells it later at a higher price. Because long options depend on short-term price movement, 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), and it did. 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 can still be substantial: you can lose 100% of the premium in a short period. 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), and it did. If the market price had stayed above $110, the option would’ve expired worthless and the investor would’ve lost the entire $600 premium.
Again, the maximum loss is limited to the premium, but the premium can still be lost quickly and completely. For that reason, 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), which is where the risk becomes most severe.
When an investor sells an option, they receive the premium immediately. That’s the appeal: the income is received upfront.
The tradeoff is risk:
Because of that risk, 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 in exchange for meaningful risk reduction. The main limitation is cost. Options expire (most last 9 months or less), so repeatedly paying premiums over long periods can reduce overall profitability.
The most common hedges involve stock positions, but 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 investment portfolios. If the market declines, portfolio losses may be offset by gains on the put. A similar idea can be used with VIX options. The VIX is known as the “fear gauge” and is correlated with market declines, so going long a VIX call can provide returns during volatile market declines.
Foreign currency options can hedge exposure to foreign securities. For example, an investor concerned about the Japanese Yen weakening could go long a Yen put. If the currency loses value, the put’s returns could offset losses due to currency exchange risk.
Investors with fixed income portfolios are always concerned about interest rate risk. If interest rates rise, bond prices fall. If rates rise substantially, losses can be significant. To offset this risk, an investor managing a bond portfolio could go long a yield-based call. As interest rates and yields rise, the option can gain intrinsic value and help offset bond losses.
Ultimately, the suitability of a hedging strategy depends on the position it covers. The premium may reduce profits, but it can also limit 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 typically used by investors with a long-term outlook on the stock, but who expect the market to be flat 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 an investor who 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 upside is capped. If the stock rises above the strike price ($80 here), the investor can’t participate in gains above $80 because the shares may be called away. This is opportunity cost (risk), which is the primary risk created by the short call.
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
Returning to the example, assume the stock rises to $125. Without the short call, the investor would’ve gained $50 per share. With the short call, the investor is forced to sell at $80 when assigned, resulting in a $5 per share gain (plus the call premium). That difference illustrates opportunity risk.
Opportunity risk is usually considered a limited risk: the investor still profits if the call is exercised. For that reason, covered calls can be recommended to almost any investor who is already long the stock (assuming the stock position itself is suitable). The call also reduces overall risk by allowing the investor to keep the premium.
Long 100 ABC shares at $75 Short 1 ABC 80 call at $4
To see how the premium can reduce loss, assume the stock falls to $0. The short 80 call expires worthless, and the investor keeps the premium. Without the call, the investor would lose $7,500 ($75 x 100 shares). The $400 premium partially offsets the stock loss, reducing the overall loss to $7,100 ($7,500 stock loss - $400 premium).
Selling calls against stock you already own 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 (with the exception of 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.
However, the investor can lose unlimited amounts if the market price rises. If the market price stays above $25, the put expires worthless; the only benefit is the premium received. The unlimited risk from the short stock position makes this strategy unsuitable for most investors.
Also notice how the name can be misleading. In a “covered put,” the put’s downside risk (when the market 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 market volatility. Two straddle strategies to know are:
Long straddle investors seek capital appreciation whether the market price rises or falls. If the market rises, the long call can be exercised to buy at the strike price and sell at the higher market price. If the market falls, the long put can be exercised to buy at the market price and sell at the put’s strike price.
If the market stays flat at the common strike price, both options can expire worthless and the investor loses both premiums. Because two premiums can be lost in a short period, 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. In the best-case scenario, the underlying stock’s market price stays flat (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 also substantial:
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:
Spreads involve the simultaneous purchase and sale of an option. The two spread strategies to be aware of are:
As you learned previously, 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 gains and limited losses.
A practical way to identify a spread’s investment objective is to determine 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 have limited gain and loss potential, 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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