SNAPSHOT: Strategies Using Put and Call Options
How It Works:
Rather than buying and selling actual stocks, you can, for a fraction of the cost, trade rights, which have their own market value. You can contract to buy and sell those stocks at specified prices until the arrangement “expires” at specified future times, usually within a year.
- Market-Neutral: Options work in all kinds of markets.
- Leverage: Using options, you can control a large amount of money with a much smaller investment. Since a small percentage change in the value of the underlying financial asset can result in a much larger change in the value of an option, large gains are possible.
- Limited risk: As long as you own the underlying stock, your losses as an option buyer are never more than the premium plus transaction expense.
- Time Is Short: Unlike other investments, you cannot simply take the long view. The cost of an option (the premium) is lost money if the underlying stock fails to move favorably and the contract expires.
- Tax Bites: Profits on option positions that are sold rather than exercised are short-term capital gains taxable at ordinary rates when the holding period is one year or less, as it usually is. This differs from gains on stocks you own, which are more often long-term holdings and taxed at lower rates.
- Volatility: Unforeseen events (e.g., a takeover rumor) may cause trading halts or a major price movement in the underlying stock and related options. If the rumored event actually occurs, the stock and option may reopen at a significantly higher or lower price, resulting in a loss that cannot be offset because the cost might be prohibitive, time has run out, or your option has been automatically exercised.
Who Should Invest:
Any investor seeking a conservative way of earning additional income on stocks already owned; any investor wanting to hedge downside risk; or any investor seeking capital gains who is willing to make use of available resources (listed later) and become knowledgeable enough to try the strategies I describe.
Options are typically priced in single digits but traded in round lots representing 100 shares of stock. A typical transaction might be XYZ at 4, meaning an option on 100 shares would cost you $400 plus commission.