Stock Options: Hedge Your Trading To Increase Your Profits

Options can be used as a speculative investment in the stock market, a protective hedge, or an additional income source. In this article we are talking about equity options, not options on futures or commodities.

            Options derive their value from the value of the underlying security, but they also have value in and of themselves and can be traded just like stocks. Trading options fall under the subject of speculative trading, which is a complex strategy we will not to go into in depth in this article. Instead we will limit our discussion to using options as a protective hedge or as an additional income source. But first, a brief overview of options.

A Brief Overview

            An equity option is a contract to buy (a call) or sell (a put) 100 shares of stock at a specified future date. For this right to buy or sell the underlying stock, you have to pay only a fraction of the current stock price. Let’s look an example of two options for Microsoft (MSFT).

            In early November 2001, Microsoft was priced at $65. If you thought Microsoft was going to go up, you could have paid $65 a share and waited to see what happened, or you could have bought a call option. At that time, a $65 call (an option to buy MSFT at $65) that would expire in January 2002 cost about $5 per share. If Microsoft did what you expected and exceeded $65 by January 2002, you could have exercised your option and bought it for $65 a share. In reality, you probably wouldn’t exercise the option and buy the stock; you would just sell the option, which would have increased in value. If Microsoft doesn’t exceed $65 a share by January – or if less, but you would have lost only your $5 a share.

            On the other hand, if you though Microsoft might go down, you could have shorted the stock for $65 and waited to see what happened. If you were wrong and the stock went to say, $100, you would have lost $35 a share – and more if the stock kept raising. Instead of taking this risk, you could have bought a $65 December 2001 put (an option to sell MSFT at $^%) for about $3 per share. If you were right and the stock went down, you could have exercised your option and sold MSFT for $65, pocketing the difference between that price and its current lower price. Again, you would more likely have sold the option, which would have increased in value. If you were wrong, if MSFT didn’t go below $65 by December 2001, the option would have become worthless, but the most you could have lost was $3 a share, regardless of how high Microsoft went.

            Let’s consider the effect of the expiration date on the option’s value. In the first Microsoft example, a $65 call option for January 2002 was priced at about $5. Compare that with a $65 call option for January 2004, which was priced at $17. Why the huge discrepancy in prices? Because the $5 option will expire worthless if Microsoft doesn’t exceed $65 in 3 months. With a 2-year option, time is on our side. It is much more likely that Microsoft will exceed $65 in 2 years. Therefore, we’d pay more for the 2-year option than for 3-month option. The other part of an option’s value is related to the strike price – the price at which you can exercise the option to buy the underlying is described as in-the-money, at-the-money, or out-of-the-money.

In-the-money means that strike price is less for a call option and greater for a put option than the current stock price.

At-the-money means the strike price is equal to the current stock price, regardless of whether it is a out or a call.

Out-of-the-money means the strike price is greater for a call option and less for a put option than the current stock price.

            Let us illustrate the difference with three-month call options for Microsoft. The stock was priced at $65 in early November; the following options all had expiration dates of January 2002:

$60 in-the-money call: $8.25

$65 at-the-money call: $5.00

$70 out-of-the-money call: $2.50

            In other words, in-the-money or at-the-money means the options is worth money today; an out-of-the-money option means it is worthless if exercised today but may be worth something in the future. Out-of-the-money options cost less but have more risk.

            Because of the time component, an option goes down in value every single day assuming the underlying stock price is unchanged. It is likely a time bomb ticking away, and on the final day – the expiration day – it doesn’t “go off” it simply goes to worthless unless the strike price is less (a call option) or more (a put option) than the stock price at the expiration date.

            Thus the risk with options is that the underlying stock has to go the direction you want and it has to do so within the time frame of the option.

            The extra risk also means extra reward. You’re able to invest a little bit of money with the potential of making a lot of money. If the stock doesn’t perform the way you anticipate, all you lose is the price you paid for the option. Realize, however, that you must be right on both the direction and the time frame.