The only low risk options are bought options. The word derivatives means high risk to most investors and traders, but used properly, bought calls and puts are very useful vehicles by which investors can take advantage to upward price movements (calls) and downward price movements (puts) for a premium.
The premium would represent only a fraction of the actual share price exposure if the investor bought or sold shares outright in the market. If only bought options are used, the most the investor is likely to lose is the cost of the premium.
What is a Call Option?
A call option gives the buyer of the option the right but not the obligation to purchase shares at a particular price (called the strike price).
The strike price is determined at the time the option contract is entered into. Generally, share options are traded on an exchange, so the buyer looks at the bid and offer price for each strike price anyway to determine an appropriate strike for the premium they need to pay.
A put option gives the buyer of the option the right but not the obligation to sell shares at the strike price.
What is a Put Option?
How Does the Investor Make Money?
If an investor holds a call option and the price of the shares has traded well above the strike price of the option, the investor's option is known to be 'in the money'. A put option is 'in the money' if the share price is trading below the strike price.
When the option is 'in the money', the investor could simply sell the option and put the profit into his or her portfolio to offset any losses or opportunity costs of not holding the underlying shares or selling out of shares which are devalued. Alternatively, depending upon the type of option, the investor could excercise his right to buy the shares (if holding a call option) or sell shares (if holding a put option).
Types of Options
Some options are European style options which means purchasers of options can only exercise their rights when the option expires.
Other options are American style options which means purchasers of options can exercise their rights anytime prior to the option expiry date.
It is therefore important to carefully check contract specifications prior to engaging in options trading. These should be easily found on the exchange website.
Application of Bought Calls and Puts
The advantage of buying a call option in times of market uncertainty like now is that investors do not need to outlay large amounts of capital to gain exposure to potential upward price movement. By paying just a fraction of the outlay in the way of a premium, the most money that can be lost is the amount paid into the premium.
Likewise, downside protection of a portfolio is easily found if put options are bought when times are good but overbought. So when the share prices do drop, the investor can sell out of the put options as opposed to selling out of shares and paying capital gains tax or worse, realising a significant loss.
Beware of Time Value of Options
When considering investing in options, be aware of when their expiry date is. As an option approaches its expiry date its value will drop at a faster rate unless it is deep 'in the money'.
Bought options are not just for guru traders. They are for average investors too. Just be sure to research the contract specifications and understand how the option works on the exchange.
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