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Investment strategies designed to take advantage of price movements in up and down markets
An options contract grants you the right—without imposing an obligation—to buy or sell a set number of shares or other assets at an agreed-upon price by a future date. Options may thus provide a way to hedge against or profit from potential market movements.
What are the benefits of options?
- Potential for additional income. Options offer the possibility of earning income over and above dividends by selling call options against shares you own.
- Diversification. Options may provide a way to diversify your portfolio for a lower initial outlay than the actual cost of the underlying assets.
- Cost efficiency. Buying options potentially increases the power of your investment dollar since your outlay may ultimately prove smaller than the total value of the contract.
- Hedging. Owning an option rather than the underlying stock allows you to target positive gains while limiting your risk to the premium—the amount you’ve paid for the option.
Options may be suitable for investors seeking:
- A way to hedge their investment exposure and manage risk
- A means of capitalizing on the projected movement of a particular stock
- Capital preservation
- Growth with income
Calls and puts
There are two main types of option contracts:
Calls. A call gives you the option to buy a fixed number of shares—or a fixed amount of some other asset—at a set price by a specified date. Buying a call assumes a bullish view—an expectation that by the expiration date of the contract, the underlying asset will exceed the strike (exercise) price by more than the premium paid.
Example: A call option allows you to purchase 100 shares of a stock at $50 at any time before the expiration date. If the stock price rises above $50, you may realize a profit by exercising your option. Should the price fall short of $50, you would simply allow the option to expire, forfeiting the premium paid.
Puts. Buying a put gives you the right to sell a fixed number of shares or other assets at a set price by a specified date. Buying a put assumes a bearish view—an expectation that the price of the underlying asset will trail the strike price before the expiration date.
Example: You own a put option to sell 100 shares at $60 before the expiry date. Should the price fall below $60 by more than the premium paid, exercising your option would bring a profit, since you’d be selling your shares for more than market value.
Risks and considerations
In addition to the risks associated with other investments, options carry the following risks:
- Potential to magnify risk. Options involve the use of leverage, which may increase certain kinds of risk.
- Liquidity risk. Options can experience shortages of liquidity that may increase execution costs.
- Calculation error risk. The incorrect placing of an order can result in buying an undesired quantity or series.
Note: Since an option is a depreciating asset, meaning it has a limited life, the extrinsic value in the option will wither away daily until expiration.
Tax considerations
Options strategies have certain tax ramifications; accordingly, you should seek professional tax advice before commencing options trading. (Extrinsic value is the difference between an option’s market price (premium) and its intrinsic price (i.e., the value if the option were exercised).
Fees
Options have certain costs, including commissions and interest charges (if executed in a margin account).