Options are an extremely versatile investment tool. From speculation to hedging, they can be used by a variety of investors seeking more control over their financial assets.
This list reflects Building Blocks shipped with VOptions:
-Long Call
-Short Call
-Long Put
-Short Put
Long Call
Description
Call buying is a strategy used if the investor thinks that XYZ will advance in price. It is important, given the risk, that the investor have a clear idea about where the stock is going and when. Simply thinking XYZ is a "great company that is sure to go up" is not enough. A Call purchase based on such vague notions is likely to cause frustration as losses mount when the advance fails to materialize.
Buying Calls: Why?
For the most part, there are two types of Call buyers:
- the bullish speculators wanting to take advantage of the leverage options can offer, and
- the investor buying a Call as a substitute for buying the stock.
Risk/Reward Characteristics
Break-even Point: At expiration, the break-even poi
nt (B.E.) is equal to the strike price of the Call option plus the Call option's premium. Before expiration, the break-even point is lower.
Profit: Profits are unlimited as long as the underline
g stock continues in advance.
Loss: Losses are limited to the premium paid for the option. At expiration, for every point XYZ is above the strike price, the Call option increases an additiona
l point in value.
Time Decay: A call option's premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Call erodes (i.e., decays). At expiration, the Call's value will equal its intrinsic value.
Changes in implied Volatility: Changes in the option's implied volatility has an effect on the "time value" portion of an option's premium. Thus, a change in
the option's implied volatility has the same effect as changing (+/-) the number of days remaining until the option's expiration.
Short Call
Description
The investor writing Call options should firmly believe that XYZ is not going up! XYZ doesn't have to go down, but it most definitely cannot go up. This is because the strategy's break-even point at expiration is a certain distance above the then current stock price. Thus, depending on the option's strike price, writing Call options can be a viewed as a neutral to bearish strategy.
Writing Calls: Why?
Writing uncovered ("naked") Call options is a strategy with very high risk for a small potential return. Given this obvious imbalance, why would a prudent investor wishing to preserve and build his or her capital write Calls?
- Unaware of less risky "bearish" strategies.
- Strongly believes XYZ "can't go any higher," and therefore, blind to the potential risks.
- Time Decay.
Risk/Reward Characteristics
Break-even Point: At expiration, the break-even point (B.E.) is equal to the strike price of the Call option plus the Call option's premium. Before expiration, the break-even point is lower.
Profit: Profits are limited no matter how large the decline in XYZ.
Loss: Losses are unlimited!!
Time Decay: A Call option's premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Call erodes (i.e
., decays). At expiration, the Call's value will equal its intrinsic value.
Changes in implied Volatility: Changes in the option's implied volatility has an effect on the "time value" portion of an option's premium.
Long Put
Description
Put buying is a strategy used if the investor thinks that XYZ will decline in price. It is often used in place of a short sale in XYZ stock. The speculative Put buyer looks for leverage, emphasizing the number of options he or she can purchase. The "insurance" Put buyer looks to protect a long position in the stock for a period of time covered by the option.
Put Purchase vs. Short Sale:
Prior to exchange-listed options, the average investor only had one choice if he or she wanted to put a bearish opinion into action - sell XYZ short. Now, with Put options, the investor can establish a bearish position while controlling the trade-offs between the position's risk and reward. Along with the difference in the profit and loss profiles, there are other non-dollar specific benefits as well.
Risk/Reward Characteristics
Break-even Point: At expiration, the break-even point is equal to the strike price of the Put option minus the Put option's premium. Before expiration, the break-even point is higher.
Profit: Profits are unlimited as long as the underlying stock continues to decline.
Loss: Losses are limited to the premium paid for the option.
Time Decay: Negative. A Put option's premium consists of both intrinsic value (if any) plus time value. As time passes, the time value portion of the Put erode
s (i.e., decays). At expiration, the Put's value will equal its intrinsic value.
Changes in implied Volatility: Changes in the option's implied volatility has an effect on the "time value" portion of an option's premium. Thus, a change in the option's implied volatility has the same effect as changing the number of days remaining until the option's expiration.
