Options Trading: Hedging Against a Loss

One way that many investors use options trading is as a hedge against possible losses in stock price that might result from market fluctuations.

When you trade in options, you have three choices as to how to make a profit. You can buy or sell the stocks (pick an option that is most likely going to be exercised), trade the option itself, or use the option as a hedge. In this article, we will briefly examine how to use options trading as a hedge against loss.

Options trading can be considered much the same as an insurance policy. If you feel that a stock price is going to drop but are hesitant to sell in the current market, then you may opt to buy a put option when the price falls just below the current market value.

In options trading, a put option is one that gives the owner the opportunity to sell their stock shares at the agreed strike price. In this way, if the stock’s value decreases, the investor can exercise this option and sell his or her shares at a profit – the higher price. Another choice is to sell the put at a profit, which reduces the cost of acquiring the stock in the market.

Of course, if the price of the stock does not decrease, then the investor loses what he paid for the price of the put. There is still an option to sell the put option before the contract’s expiration date and recoup most of this cost, if desired. Or you could also put in a stop-loss order to your broker in order to prevent a loss. This is just another method of loss insurance.

While using options trading as a way to hedge against losses can be a great strategy for the experienced trader, it may not be the best choice for a novice investor. Take some time to get used to reading market conditions and improving your accuracy regarding rising and falling prices before relying on options trading as a portfolio insurance policy.

Learning to trade options is not difficult. I certainly had no prior knowledge of trading the markets until I stumble on Planet Wealth's ebooks, which have been a great resource for my learning. Make no mistake, options can be tricky to trade, but when armed with the knowledge, it can be one of the most powerful instruments you can use to make money in the markets without having to monitor it 24 by 7.

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Straddles - A Neutral Options Trading Strategy

Previously, I have tackled directional options trading with Credit Spreads. Directional Trading means trading the markets or a specific stock with a specific view of it going up or down (bullish or bearish). This week, I'd like to focus on a different options trading strategy called Straddles.

A Straddle is a neutral or non-directional options trading strategy. In essence, neutral or non-directional options trading strategies are opted by options traders when he has no idea as to whether a particular stock would rise or fall. In such options trading strategy, the profit potential is assessed on the basis of speculative volatility of a particular stock price. There are 2 types of straddles: a Long Straddle and a Short Straddle. This post will cover the Long Straddle as an options trading strategy.

Long Straddle

A Long straddle is basically comprised of a Buy Call and Buy Put Options. The idea is you are buying a call and a put on same strike price. With this options trading strategy, if the market goes in one direction, one of the options will increase in value significantly, and the other will become worthless. For a long straddle to be effective, the price of a stock should either take a huge jump or go for a steep decline. This is very handy for times when the market is very volatile, and the volatility can enable you to earn unlimited amounts based on how much the stock price has risen or fallen.

Profits are calculated based on where the stock price is. If the stock price is above the strike price of the option, then the profit will be as follows:

Price of the stock - Strike Price of the Call option - Net Premium Paid

If the stock price is below the strike price of the option, then the profit will be as follows:

Strike Price of the Put Option -Price of the stock -Net Premium Paid

For example:
Company XYZ is trading at $40. You do a straddle by buying 10 call and 10 put options of $40. You paid $400 in premium.

If at expiry date the stock price is now at $50, then your profit is as follows:
($50 x 10 contracts) - ($40 x 10 contracts) - $400

If at expiry date the stock price is now at $30, then your profit will be:
($40 x 10 contracts) - ($30 x 10 contracts) - $400

If the stock price did not move at all by expiry date, you lose the premium you would have paid, and both options have now expired worthless.

If you would like to learn more about Straddles and options trading in general, I found that Planet Wealth provides very comprehensive information on stock and options trading, and the various strategies that you can use depending on the market situation.

On my next post, I will be covering short straddles. I hope you've enjoyed this post and learned something from it.

Another sharemarket secret unveiled!

Options Trading Terminologies

Basics on Options Trading

I'd like to get back to basics and explain what options trading is. Options Trading is basically the trading of options contracts that is exchanged between the buyer and the seller of an asset (in the case of the stock market, the stocks). That gives the buyer the right to either buy or sell a particular asset at an agreed date and at an agreed price. In return, the seller of the option receives a certain amount of payment as premium from the buyer. There are 2 types of options: A call option and a put option.

Call Option
Call Option gives the holder the right but not the obligation to buy the stock for an agreed price at an agreed time. If the call option is struck or exercised, the buyer of the call option is then able to purchase that particular stock for the agreed price, and the seller of the call option is then obliged to sell the stock at the agreed price.

Put Option
Put Option gives the holder the right but not the obligation to sell the stock for an agreed price at an agreed time. If the put option is struck or exercised, then the buyer of the option is obliged to sell the asset or stock. The seller of the put option, if exercised, is then obliged to buy the stock or asset.

What does "Exercise" mean?
Exercise means that the price of the stock has hit or exceeded the agreed price on the option on or before the specified agreed date. This means that the options contract has to be executed, and that is what "being exercised" mean.

Options Contract
Options are traded by contracts. A contract is comprised of:

• The quantity and the class of the assets (in the US, a contract is 100 shares , in Australia a contract is 1,000 shares)
• The exercise price at which the options trading happens;
• The expiry date
• The premium price that would be settled to the writer (or seller) of the contract, OR the premium to be paid to the taker (or buyer) of the contract.

Options trading follow different styles. The most common ones are:

• American options trading – In this options style, an option can be comfortably exercised on on any trading day on or before the expiration date.
• European options trading - In this options trading style, the options can only be exercised at the time of expiration only.

These are just the basics of options trading. More information is available with Planet Wealth and the e-books that they offer, which I find are just awesome with explaining the finer details of Options trading.

I hope this has been a beneficial post on Options Trading by Planet Wealth Systems!