Risk Managing: Options As A Strategic Investment

Options as a strategic investment make sense for some investors because they can take advantage of the market fluctuations. Also, options can minimize risk because they provide an established length of time for investment opportunities. a

Option Contract
Option investing involves a contract that is entered into between two parties. The option holder is an investor who buys the right to either buy or sell a stock. The option writer has an obligation to buy or sell a stock. This is stipulated in the contract, which is fixed at a set price known as the exercise or strike price. An option contract is typically good for 9 months. If the holder does not exercise it within that period, it expires and becomes worthless.

There are two types of option contracts, calls and puts. A call is the option to buy a stock at the exercise price. A put is an option to sell a stock at the contract’s exercise price.

Option Holder’s Perspective
An option contract is viewed from the perspective of the holder. This is because the holder has the right to exercise the contract anytime before it expires. If it expires before the holder takes action, the contract expires. Both the holder and the writer may close an option contract at any time prior to expiration by making an opposing transaction. For a holder, they would write a matching contract whereas the writer would buy it.

Income and Hedge Strategies
Two basic strategies that are employed by option holders and writers are income strategies and hedge strategies. These strategies involve the buying and selling of calls and puts in order to protect a stock portfolio or provide additional income for the portfolio. Both of these types of strategies involve risk, depending on which side of the transaction you are.

  • Income strategies involve an option writer who sells either a call or put and receives a premium. When an option investor writes a call or put the premium received represents the maximum profit that can be earned. The writer has an obligation to the holder to buy or sell the underlying stock during the option’s period up to the expiration date. After expiration, the writer relinquishes their obligation and walks away with the premium as their profit.
  • Hedge strategies are seen as protection against long and short stock positions in a declining or rising market. If you own a stock, you are interested in minimizing your losses in case the market falls. This is accomplished by purchasing an insurance policy or put option at an exercise price at or above the price of the stock. As the market declines, you can exercise the put and sell the stock to the corresponding writer at the exercise price. The premium that you paid as the option holder is your maximum loss.

Options strategies make sense for most every investor and should be considered as part of your investment approach. Investing in option contracts involves risks and does not guarantee that a profit will be made.

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