Option Strategies for Speculation and Hedging

10.8 Option Strategies for Speculation and Hedging

Options are versatile financial instruments that can be used for both speculation and hedging. In this section, we will explore common option strategies employed by individual and institutional investors, focusing on buying calls and puts, and writing covered and naked options. We will provide detailed examples to illustrate how these strategies work in practice, and discuss the associated risks and rewards.

Understanding Options

Before diving into specific strategies, it’s important to understand the basic components of options:

• Call Option: A contract that gives the holder the right, but not the obligation, to buy an underlying asset at a specified price (strike price) within a specified time period.
• Put Option: A contract that gives the holder the right, but not the obligation, to sell an underlying asset at a specified price within a specified time period.

Buying Calls and Puts

Buying Call Options

Objective: Speculate on the price increase of an underlying asset.

Example: Suppose you are bullish on RBC (Royal Bank of Canada) stock, currently trading at $100. You purchase a call option with a strike price of $105, expiring in three months, for a premium of $2 per share. If RBC’s stock price rises above $107 (strike price + premium), you start to profit.

Risks and Rewards:

• Reward: Potentially unlimited upside if the stock price rises significantly.
• Risk: Limited to the premium paid ($2 per share).

Buying Put Options

Objective: Speculate on the price decrease of an underlying asset or hedge against potential losses in a portfolio.

Example: You own shares of TD Bank and are concerned about a potential decline. You buy a put option with a strike price of $95, expiring in three months, for a premium of $3 per share. If TD’s stock falls below $92 (strike price - premium), you start to profit.

Risks and Rewards:

• Reward: Significant profit potential if the stock price falls sharply.
• Risk: Limited to the premium paid ($3 per share).

Writing Covered and Naked Options

Writing Covered Calls

Objective: Generate additional income from an existing stock position.

Example: You own 100 shares of BCE Inc., currently trading at $60. You write a call option with a strike price of $65, expiring in one month, for a premium of $1 per share. If BCE’s stock remains below $65, you keep the premium as profit.

Risks and Rewards:

• Reward: Earn premium income while holding the stock.
• Risk: Limited upside if the stock price exceeds the strike price, as you must sell the stock at $65.

Writing Naked Options

Objective: Speculate on the price movement of an asset without owning it.

Example: You write a naked call option on Shopify, with a strike price of $150, expiring in one month, for a premium of $5 per share. If Shopify’s stock remains below $150, you keep the premium as profit.

Risks and Rewards:

• Reward: Earn premium income without owning the stock.
• Risk: Potentially unlimited losses if the stock price rises significantly.

Practical Examples and Case Studies

Case Study: Canadian Pension Fund

A Canadian pension fund uses options to hedge its equity portfolio. By purchasing put options on the S&P/TSX Composite Index, the fund protects against a market downturn, ensuring that its portfolio value does not fall below a certain level.

Case Study: Individual Investor

An individual investor uses a covered call strategy on their TFSA (Tax-Free Savings Account) holdings. By writing call options on their existing stock positions, they generate additional income while maintaining the tax advantages of the TFSA.

Diagrams and Visual Aids

Below is a diagram illustrating the payoff of a covered call strategy:

    graph LR
	    A[Stock Price at Expiration] --> B[Below Strike Price]
	    A --> C[Above Strike Price]
	    B --> D[Profit = Premium]
	    C --> E[Profit = Premium + (Stock Price - Strike Price)]
	    E --> F[Profit Capped]

Best Practices and Common Pitfalls

• Best Practices: Always assess the risk-reward profile of each strategy and consider your investment objectives and risk tolerance.
• Common Pitfalls: Avoid writing naked options without understanding the potential for unlimited losses. Ensure you have sufficient capital to cover potential obligations.

Conclusion

Options offer a range of strategies for both speculation and hedging. By understanding the mechanics and risks of each strategy, investors can make informed decisions that align with their financial goals. Whether you are looking to speculate on market movements or protect your portfolio, options can be a valuable tool in your investment arsenal.

Glossary

• Covered Call: Writing a call option while owning the underlying asset, mitigating potential losses but capping upside gains.
• Naked Option: Writing an option without holding the underlying asset, exposing the writer to unlimited risk.

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