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Options have gathered popularity as risky investment instruments. But do you know, options were invented to reduce risk? To give you an idea of options risk reduction ability, no amount of portfolio diversification across stocks or bonds could protect investor’s money from the 2008 financial crisis or the March 2020 pandemic crisis. It was only the options that protected investors from the downside risk.
The options market is the game field of hedge funds that use these instruments to make money. But with time, the options market has evolved and is now garnering the attention of retail investors.
How Conservative Risk Averse Investors can use Options Trading Strategies in 2021
Options Where Risks Change Hands
There are two types of investors, risk-averse and risk-takers. Both of them come to the options market with a different objective in mind. Risk-averse investors are the ones who own an asset or wish to buy or sell an asset. They come to the options market to hedge their asset against price volatility.
For instance, Mary owns a house worth $500,000. She takes home insurance and pays a premium to the insurance company to bear the risk of theft, fire, or any such event that will bring huge losses. Mary wants the insurance to mature without requiring to claim any loss. Her objective is to reduce the risk of contingency, and she doesn’t mind losing the premium money.
The insurance company is a risk-taker, and it is here to make money from the premium. It agrees to take Mary’s risk. Just like insurance, options seller benefits from premium money on unexercised options. The option premium increases if the duration is longer (8 months to 1 year), the underlying is costlier, and the price volatility is high. In simple terms, the higher the risk higher the premium.
Common Options Trading Strategies for Risk-Averse Investors
Options are a zero-sum game where one trader’s loss is another trader’s profit. When you enter the options market, be very clear of your objective – hedging or profit-making. It is your objective that will determine your options strategy. It is not necessary that you only hedge risk and keep losing premium money, as in the case of home insurance. In the options market, you can also make money or reduce your premium cost while reducing risk.
If you are a beginner, you can start with three of the most common risk-reducing options strategies.
Covered Call Strategy
Many mutual funds adopt this strategy to maximize their returns on a stock. You own 100 shares of stock E, which is trading at $100. You believe that the stock will not rise beyond $120. Based on what you think, you can sell a call option for stock E and at a premium of $2/share.
If your hunch is right and the stock price surges to $120, you can sell the stock to the call options buyer at the strike price and even get a $2 premium for it. This enhances your profits to $22/share but also limits it to this amount. If the stock grows further, the call buyer benefits.
If the stock price falls to $95 at expiry, the options premium will reduce your loss to $3/share instead of $5. A covered call helps you enhance your upside and reduce your downside by the amount of option premium.
Protective Put Strategy
The protective put strategy is the exact opposite of the covered call strategy. You are worried that your 100 shares of stock E will fall from the current trading price of $100 to $80. Based on what you think, you can buy a put option with an $80 strike price.
If your fear is right, and the stock falls to $80 at or before maturity, you can exercise your put option and sell the stock at $80 to the put writer, limiting your loss to $20/share plus the options premium.
You can also reduce the downside to just the premium price by buying a put option with a strike price of $100.
Cash-Secured Put Strategy
A step ahead of the protective put is the cash-secured/naked put strategy. In this strategy, you don’t own stock E yet but want to buy the stock.
In the stock market, the best strategy is to buy the dip. What if you get paid for buying the dip? That is what naked put does.
For instance, stock E is trading at $100, and you want to buy it at $80. You sell the put option with an $80 strike price and get a premium of $2. If the stock falls below the strike price, you will be obligated to buy the stock at $80. You buy the stock at the price you wanted, plus a premium, thereby reducing your purchase price to $78.
But if the stock price rises to $110, your put option goes unexercised, you don’t own the stock, but you earn the premium money of $2. Most options writers want the option to go unexercised.
How to optimize the cost of your options
In the options market, it is the writer of the option who bears the risk in return for a premium. When you are the option’s writer, a higher premium enhances your returns. But when you are the option’s buyer, a higher premium reduces your returns.
For instance, Mary buys a 1-year put option expiring in December 2021 for a total premium of $500. The options price starts deteriorating few months before the expiry. In Mary’s case, her put option’s price may reduce to $350 in July 2021. She can sell her put option at $350 and buy another December 2021 put option at a lower price, thereby reducing her premium cost.
Like Mary, even you can reduce the cost of the options and increase your returns without increasing your risk.
These are some simple options strategies that you can implement with basic knowledge of options. There are many more complex strategies to maximize returns and minimize risk, but they require a deeper understanding of options.
You can start with the basics, understand the lingo, get comfortable with options charts and how options work. As you read and discuss more options strategies, you will learn the tricks of the trade. Gradually, you may start profiting from options while hedging your risk.