Earlier, we introduced the three uses of options—to generate income, speculate, and hedge. Now, let’s explore these three uses in more detail to help you understand how each works.
First, options can be used to attempt to generate income and potentially enhance your returns. With these strategies, you take on the role of an option seller. Option sellers take on obligations and more risk, and for this they are rewarded with the options premium. The goal with these strategies is to sell options and have them expire worthless. To option sellers, this is a great outcome because it allows them to collect premium and avoid their obligations tied to the contract. However, if things don’t go their way, they’d likely incur a loss or be forced to buy or sell the underlying stock position.
When constructed in certain ways, income strategies like these can be high-probability trades. This means the odds that the trade will be profitable may be in the seller’s favor. That being said, this high probability of success means potential returns are typically low for any winning trades. It’s also important to note that high probability doesn't mean low risk. A few of these strategies have high potential maximum risk because they’re tied to owning a stock. While unlikely, the worst possible outcome of owning a stock is the stock falling to zero. And strategies where you don't own the underlying shares are among the riskiest options strategies out there, as you’ll learn later in this course.
Options can also be used to speculate on the future price movement of a security. Speculative trades often take on greater risk with the hopes of greater potential returns, and they tend to be based more on price movement than any fundamental value in the underlying. There are a variety of ways to speculate with options; for example, you can place a low-probability trade with the potential for significant returns, or construct a trade with a probability of success similar to buying and selling stock.
Speculation is generally high-risk trading focused on short-term price changes. With the speculative strategies discussed in this course, the probability of success is comparable to owning stock in the very short term—about 50/50 odds of success. Because these strategies have a lower probability of success, they should only be considered by traders willing to accept both the risks and the low probabilities of success. They’re intended for active traders—those who have not just the risk tolerance but also the time to learn strategies and manage trades, as well as the financial resources and personality to bear with the market’s ups and downs.
Finally, options can also be used to hedge a position or portfolio. A hedge is a protective strategy designed to offset risk or loss in a portfolio. The trader agrees to pay a relatively small amount in return for a measure of protection for a limited period of time if things go wrong. With a hedging strategy, you attempt to reduce a certain level of your risk and transfer it to someone else.
Say, for example, you hold a stock position that’s recently rallied. It’s done so well that you become concerned it has rallied a little too much and may soon enter a small downtrend. You could pay a relatively small premium and buy a certain type of option that helps hedge your stock position.
For illustrative purposes only.
If things go against you, you may be able to lock in your profits. However, if the stock keeps going up, the amount you paid for the option will offset some of your gains. But the amount you have to pay for the option is much smaller than the amount it could protect if things go wrong.
Unlike income strategies, hedging strategies are usually low-probability trades. In other words, they aren’t as likely to be successful, which is by design. After all, the preferred outcome is for a hedge to be unnecessary. Losing money on the hedge or having it expire worthless means you probably made (or at least didn’t lose) money on the position you were trying to protect. While hedging strategies aren’t covered in this brief course, consider researching “protective puts” if you’re interested in learning more about hedging strategies.
Each of these purposes—generating income, speculating, and hedging—could play a role in your overall options approach and in your portfolio. That’s the thing about options: there’s a lot you can do with them.