How can you use options to protect against market risk?

1 What are options?

Options are financial instruments that derive their value from an underlying asset, such as a stock, an index, a commodity, or a currency. There are two types of options: calls and puts. A call option gives you the right to buy the underlying asset at a predetermined price (called the strike price) before or on a certain date (called the expiration date). A put option gives you the right to sell the underlying asset at the strike price before or on the expiration date. You pay a fee (called the premium) to buy an option, and you receive a premium to sell an option.

2 How do options hedge market risk?

Options can hedge market risk by allowing you to reduce or eliminate your exposure to unfavorable price movements in the underlying asset. For example, if you own a stock that you expect to rise in value, but you are worried about a possible decline, you can buy a put option on the same stock with a strike price below the current market price. This way, if the stock price falls below the strike price, you can exercise your put option and sell the stock at the higher strike price, offsetting your loss. On the other hand, if the stock price rises above the strike price, you can let your put option expire worthless and keep your stock, benefiting from the increase.

3 How do options lock in profits?

Options can lock in profits by allowing you to secure a favorable price for your underlying asset without selling it. For example, if you own a stock that has risen in value, but you are not ready to sell it yet, you can sell a call option on the same stock with a strike price above the current market price. This way, you receive a premium for selling the call option, and you keep your stock as long as the stock price stays below the strike price. However, if the stock price rises above the strike price, the buyer of the call option can exercise it and buy your stock at the lower strike price, limiting your upside.

4 How do options create income streams?

Options can create income streams by allowing you to generate regular cash flow from your underlying asset without giving up ownership. For example, if you own a stock that pays dividends, but you want to increase your income, you can sell a call option on the same stock with a strike price slightly above the current market price and an expiration date close to the dividend payment date. This way, you receive a premium for selling the call option, and you collect the dividend as long as the stock price stays below the strike price. However, if the stock price rises above the strike price, the buyer of the call option can exercise it and buy your stock at the lower strike price, forgoing the dividend.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?