The advantage of using options, and for that matter all derivatives, is due to the leverage that they provide. Leverage provides the potential to make a higher return from a smaller initial outlay than investing directly in the underlying asset.
For example, a $2000 investment in BHP call options could provide leverage to 2000 BHP shares during the life of the option (if the option premium is $1). To get the same exposure (to 2000 BHP shares) by buying shares directly, it would cost you $90,000 if BHP is trading at $45! So a $2000 investment in call options gives you the same exposure as a $90,000 investment in shares… now that’s what leverage is!
Options can be used very much like insurance to protect a portfolio or to guard against extreme movement in a particular stock. This is also referred to as hedging.
For example, if you own 5000 BHP shares at $45 and you are worried that the share price may fall, you can buy 5 BHP $45 put options to hedge your position. This enables you to lock in an acceptable future sale price, protecting you should your fears be correct and the stock falls.
One thing to take note of is that as the BHP share price falls, BHP put option premiums rise. Why is this? As the share price drops, those same put options that you bought become more valuable. You see, if BHP drops to $42, your $45 put options still give you the right to sell BHP at $45. So the lower the share price falls, the more ‘in the money’ (more on this next) your put options become, resulting in a greater premium.
This profit on your put options should offset your loss on the physical shares… that’s what hedging is. You then have the option of either exercising your right to sell your BHP shares at $45 or, if you want to keep your BHP shares, simply selling your BHP put options at a nice profit.
If a market participant wants or needs to defer an investment, they can buy the equivalent market exposure for a short period of time.
For example, let’s say you want to buy 1000 NAB shares at the current price of $40, but you won’t have the $40,000 in capital (required to make that investment) for another three months. You could simply wait three months, however, you are concerned that the stock will rise between now and when you can buy it, resulting in you missing out on the upside.
You can lock in the future buy price today by buying a NAB $40 call option which expires in roughly three months time. That way, if NAB goes up between now and when you have the $40,000 in three months time, you won’t have missed out on any upside.
One thing to take note of is that as the NAB share price rises, NAB call option premiums rise. Why is this? As the share price rises, that same call option that you bought become more valuable. You see, if NAB rises to $45, your $40 call option still gives you the right to buy NAB at $40. So the higher the share price goes, the more ‘in the money’ (more on this next) your call option becomes, resulting in a greater premium.
This profit on your call option should make up for what you missed out on by not being able to buy the physical shares when you wanted to. You then have the option of either exercising your right to buy NAB shares at $40 or simply selling your NAB call option at a nice profit.
A portfolio can be diversified by different option strategies. If a portfolio is overweight or underweight in a specific sector of the market, a strategy may be considered to shift the risk exposure of the portfolio.
For example, if a portfolio is particularly overweight one stock such as Telstra (TLS), the investor may choose to protect that part of the portfolio via an options strategy, such as buying TLS put options. As mentioned, this is basically the same as buying insurance on those TLS shares.