Question:

Why trade options?

Ability to profit in both bull and bear markets

This is certainly a claim that none of the traditional mutual fund families can make, and it is at the heart of why experienced options traders have profited in the volatile recent markets. By buying put options, you can achieve leveraged profits with limited dollar risk when a stock declines in price. Of course, leveraged gains can be achieved on bull moves by buying call options, but bull market profits comprise only half of the total options profit picture.

Limited dollar risk and limited dollar exposure

As an option buyer, you benefit from being able to control the movement in a stock for just a fraction of the cost of purchasing that stock. Plus, you can never lose more than this modest dollar amount. As a result, you can keep the bulk of your investment dollars in the safety of cash where it is immune to the wild and often scary swings in the market.

Speculation

Speculation is a common use of equity options, and is probably why many of those unfamiliar with options typically associate them with risk. Option speculators are attracted by the large potential returns linked with buying options. In short, buying options allows one to achieve leverage, make money in up and down market conditions, and control a number of shares with a small capital commitment.

Generate income or lower breakeven

Another use of options is to generate income on stock positions already held, or to lower the breakeven on stock positions being purchased. This is done by selling an out-of-the-money call (this option has a strike price that is above the current stock price). When selling a call to open a position, you take on the obligation (if the buyer of the call exercises his right) to deliver the shares at a certain price (strike price) by a certain future date (expiration date). When selling options, you pocket the premium received from selling the option. When used in this manner, the owner of the stock sells calls because he thinks the stock will stagnate over the short term. The sold call generates income even if the stock fails to stage a rally.

Hedging a position

Options can also be used to hedge against positions already held in an equity portfolio. If you're concerned that the market may fall over the next several months, but don't want to sell the stocks in your portfolio, you can acquire "portfolio insurance" by purchasing index put options.

In the simplest terms, put options will rise in value when the underlying index falls in price. Therefore, some or all of the losses sustained due to the decline in value of the stocks in your portfolio are offset (or partially offset) by the increase in value of the purchased put option.

Accumulating stock

The last option strategy uses options to accumulate stock positions by selling puts to acquire a stock below market value. A put seller takes on the obligation to purchase the shares at a predetermined price (strike price) before or on a future date (expiration date). If by expiration the stock doesn't pull back to a level where the put buyer wants the put seller to purchase the stock, the put seller simply pockets the premium from the put sale and has no additional obligations. We call this "getting paid to wait." If the stock does pull back far enough and the put is exercised, the put seller must purchase the shares. In this scenario, and similar to the distribution discussion above, the put seller was paid to place a limit order to buy the stock. Furthermore,the put seller acquires the shares at a price below that in effect when the put was originally sold. Plus, he retains the premium from the put sale, which lowers his net cost to acquire the shares.

Distributing stock

Selling call options against a stock can also be implemented when one is looking to distribute the stock and raise a little extra cash in the process. Another way of looking at this is getting paid to place a limit order to sell the shares. Selling an in-the-money call option (the strike price is below the stock's current price) increases the likelihood of the option being called away (i.e., the call buyer exercise his right to take delivery of the shares at the strike price). In this case, the seller receives more protection on a downside move and gives up all upside potential in the shares. On the other hand, selling an out-of-the-money call against a held stock decreases the likelihood of the stock being called away. Thus, there is less protection against an adverse move in the stock, but the seller is allowed to capture some of the upside in the shares between the time the option was sold and its expiration date.

Leverage

You can achieve percentage gains from your successful options investments that are 5, 10, and even 20 times the gains achieved by stock or mutual fund investors.