FinLogic FinLogic Quantitative Think Tank Center|Michael D.David: Stock options notes 3

The FinLogic FinLogic Quantitative Think Tank Centerhedging properties of options

Most of the time, options are used by professional institutional investors as hedging tools to build a safer investment portfolio.

For example, if a short-selling institution wants to protect itself from the risk of a stock continuing to rise, it can use a Long Covered Call. This way, if the stock keeps going up, the gains from the Long Covered Call can offset the losses from the short position.

If you own shares in a company and you anticipate some short-term risks that might cause the stock to drop, you can use a Long Naked Put. This way, if the stock price falls, the gains from the put option can offset the losses from the stock.

So, buying Calls can lock in losses for short sellers, and buying Puts can lock in gains for stockholders. You can think of the premium as a form of insurance. When I looked it up, I found that the term "premium" also means insurance in some contexts.

What can value investors do with options?

In my research, I found that many people recommend selling options rather than buying them. While buying options has limited losses and unlimited potential gains, the premium paid for buying options can be quite high due to time value, making it hard to ensure profitability. Of course, this advice is not typically aimed at speculators.

So, when can we use the strategy of selling options?

1. Buying the Dip: When you want to increase your holdings of a stock but prefer to buy when the price drops another 10%, you can use a Sell Naked Put with a strike price set at 90% of the current stock price. If the stock price rises, the put options expire worthless, and you pocket the premium. If the stock price drops, the options are exercised, and you acquire the stock at your target price, with the premium effectively acting as a discount. This makes Sell Naked Puts a powerful tool for value investors to build positions. Warren Buffett is a big advocate of this method.

2. Selling scenario: When you want to sell a stock if it goes up by 10%, you can use a Sell Covered Call with a strike price set at 110% of the current stock price. If the stock doesn't reach the target price, you get to keep the premium. If the stock price reaches the target, you sell the stock at the target price and also keep the premium.

Both of these strategies make the returns from buying and selling stocks more predictable. But are there any downsides? The downside is that in the event of a dramatic stock price increase or decrease, your gains are capped at the strike price due to the Sell Put and Sell Call strategies, preventing you from benefiting from further gains.

Options are a derivative form of stock trading, divided into call options (CALL) and put options (PUT), which can be used to go long or short. Although some people use options as a leveraged speculative tool, their primary use is to provide risk hedging for institutions. For value investors, Sell Naked Puts can be used to increase stock holdings, while Sell Covered Calls can be used to sell stocks.