10.5.3 Option Strategies For Individual And Institutional Investors

Overview

The range and complexity of options trading strategies are practically limitless. In this guide, we will examine eight option strategies commonly used by individual and institutional investors. Each strategy is either a speculative or risk management strategy, and each is based on exchange-traded options on the fictitious company XYZ Inc.

Note: To keep things simple, commissions, margin requirements, and dividends are ignored in all examples.

Dive Deeper

If you want to learn more about options, consider the Derivatives Fundamentals and Options Licensing Course (DFOL) offered by CSI. It explains the strategies commonly used in the market to speculate or to hedge portfolios.

Assumptions

For all of the strategies presented below, assume we are currently in the month of June and that XYZ Inc. stock is trading at $52.50 per share. The discussions that follow use one of the four options listed below.

Buying Call Options

Investors buy call options with either of two strategies in mind: to speculate or manage risk.

Buying Calls To Speculate

The most popular reason for buying calls is to profit from an expected increase in the price of the underlying stock.

Example: Buying Calls To Speculate

Assume that an investor buys five XYZ December 55 call options at the current price of $2.

Breakdown of the purchase:

• Five contracts
• Underlying stock: XYZ
• Expiration month: December
• Strike price: $55
• Premium: $2 each

Investor pays a premium of $1,000 (calculated as $2 × 100 shares × 5 contracts).

If XYZ stock price rises to $60 by September, the XYZ December 55 calls will likely trade at about $6.70, assuming a time value of $1.70. Therefore, the holder could sell the options at $6.70 and realize a profit:

$$ \text{Profit per share} = (6.70 - 2.00) \times 100 \times 5 = \$2,350 $$

However, if XYZ stock drops to $45 by September, and the option price drops to $0.25, the holder incurs a loss:

$$ \text{Loss per share} = (2.00 - 0.25) \times 100 \times 5 = \$875$$

Rate of Return Calculations:

For a profit of $4.70 per share:

$$ \text{Rate of Return} = \frac{4.70}{2} \times 100 = 235\%$$

For a loss of $1.75 per share:

$$ \text{Rate of Return} = \frac{-1.75}{2} \times 100 = -87.5\%$$

Buying Calls To Manage Risk

Calls can also be used to establish a maximum purchase price for the stock or to protect against losses on a short position.

Example: Buying Calls To Manage Risk

Assume a fund manager plans to buy 50,000 shares of XYZ by December and uses 500 XYZ December 55 call options as insurance.

If XYZ shares increase to $60, the effective cost per share for the call buyer would be $57 ($55 strike price + $2 premium). If shares fall to $45, the call buyer will let options expire, buying shares at $45, with an effective cost of $47 ($45 market price + $2 premium).

Writing Call Options

Covered Call Writing

Covered call writers own the underlying stock and can meet obligations if assigned.

Example: Covered Call Writing

Investor buys 1,000 shares of XYZ at $40 and writes 10 XYZ September 50 call options at $4.55.

Naked Call Writing

Naked call writers don’t own the underlying stock and face theoretically unlimited risk.

Example: Naked Call Writing

Investor writes 10 XYZ September 50 call options at $4.55, without owning shares.

If XYZ rises to $60 at expiration:

Buying Put Options

Buying Puts To Speculate

Investor buys puts expecting stock price to fall.

Example: Buying Puts To Speculate

takes the risk calculations further

Investor buys 10 XYZ September 50 put options at $1.50.

If XYZ falls to $45 by one month before expiration, the put price might be $5.25 including some time value.

Total profit calculation:

$$ \text{Profit per share} = (5.25 - 1.50) \times 100 \times 10 = \$3,750$$

If XYZ rises to $60 instead, points missed in calculations – effectiveness and retention.

Total loss calculation:

$$ \text{Loss per share} = (1.50 - 0.05) \times 100 \times 10 = \$1,450 $$

Buying Puts To Manage Risk

Investors can use puts to hedge their investments.

Example: Buying Puts To Manage Risk

Investor owns 1,000 shares XYZ and buys 10 XYZ September 50 put options worth $1.50 each for downside protection.

If XYZ falls to $45 by expiration:

• The intrinsic value of put: $50 - $1.50 paid per put. The minimum price = floor created by the put strike price.
• Intrinsic value: $5 making for better retention through intrinsic value.

Overall: Manage risk through options to improve portfolio security and gain strategically from changing markets progressively.

Strategy Overview & Risk Metrics

Options trading strategies can be crafted to optimize returns while maintaining controlled risk levels. Through comprehensive financial engineering, these strategies contribute to a deeper understanding of market dynamics and facilitate the enrichment of returns.

Key Points:

• Optimized Returns: Well-constructed options strategies can significantly enhance portfolio returns by leveraging market opportunities.
• Controlled Risk: Carefully designed strategies help in bounding risk, ensuring that potential losses are managed effectively.
• Financial Engineering: Detailed financial engineering helps in the precise construction and execution of options strategies.

Continuous Improvement:

• Revised Insights: Regular reviews and updates to strategies ensure they remain aligned with current market conditions and data insights.
• Accurate Annotations: Persistent refinement and accuracy in annotations support better decision-making and strategy implementation.