Hedging and Speculating With Options

Hedging & Speculating With Options: How to Enjoy Guaranteed Monthly Income

By Lee Lowell, Advisory Panelist
Tuesday, July 19, 2005: Issue #226

As far as I know, there are three ways to use options:

Hedging
Speculating
Generating cash flow income

I would guess that most investors associate options mostly with speculating.

But options are surprisingly versatile investments. You can even use them to reduce risk. Not to mention generating steady income!

Let’s take a look at the three ways you can profit from options, to put each into perspective, including exactly how you can use options as income vehicles simply by selling them instead of buying them…

The Best Way to Speculate With Options

The first way, “speculating,” gets the most attention, and is probably the way most people use them. And it’s also the reason why most people lose when trading options.

The reason why I say this is because most people like to gamble, and options offer you a great way to gamble. Speculating = gambling.

You can buy close-to-expiration, far out-of-the-money (OTM) options for $5, and if the stock makes a huge move, you can theoretically make five, six, or 10 times your money.

This is the lure of buying cheap options. It’s like buying a lottery ticket. If you hit the big one, you’ve won. But the probability of hitting that big one (like winning the lotto) is so small that most people end up throwing away their money.

The mentality goes something like this: “These options only cost me $50, so if I lose it, no big deal.” That’s fine if it’s a one-time shot, but if you make it a habit, or part of your daily routine, those $50 losses can add up over time.

You need to be really accurate in your market direction assessment, and you have to be extremely timely, as well.

If the stock doesn’t make the move quickly, your OTM options die very quickly. This is most likely the reason you hear others telling you to stay away from options, because they knew someone who lost all their money playing them.

Speculating is the reason why, as well as leverage. Options offer you great leverage and investors tend to abuse it. If you want to speculate on the direction of a stock or index, take my advice and use deep-in-the-money options (DITM) on two- or three-year LEAPS.

How to Hedge Using Options, Just Like the Big Boys

The second way to use options is through the process of “hedging.” Hedging is a term that refers to a way of protecting something that is already in place. In regards to the investment arena, hedging helps protect any long or short stock position from adverse movements.

If you are long a stock, then one of the best ways to protect yourself against a fall in the share price is to buy put options on that stock. Similarly, if you are short the stock, then you can buy upside calls to protect yourself against a short squeeze.

The strike prices that you select for hedging purposes will coincide with support and resistance levels where you would have set your loss limits if you just outright had the stock without any hedging protection.

There are other more intricate strategies to use, but outright put and call buys are a great way to hedge (protect) an existing stock position.

You Could Use Bonds for Income – But Options Work, Too

The last way to use options is in the form of generating monthly cash flow. This strategy allows you to sell options against an existing stock position to help offset some of the purchase price of the stock, and to give you an extra boost to the paltry interest you’re earning from your bank or brokerage account.

When you sell options, you are the one collecting the option premium and pocketing the money. Option buyers always pay out the money.

The most common form of generating cash flow, and one of the most widely used by investors, is that of “covered call writing.” This is a strategy in which the investor already has long shares of a stock in his account and opts to sell a call option against that position. The strike price is usually out-of-the-money (OTM), which allows the investor to immediately pocket the money, but also gives the stock price some room to appreciate, as well.

Depending On Your Outlook

For the stock, you can tailor how far OTM the strike price needs to be before selling the option. If you don’t want to give up your stock in the case of assignment of the short call option, you would sell a far OTM call that still gives you a decent premium.

You might have to go out to a further expiration month to get it, in that case. Other investors wouldn’t mind selling their stock if it hits a certain price, so they will pick an option strike price at that level. If the stock gets to their predetermined level, they will be assigned on the short call and be forced to give up the stock.

If the short call expires worthless, then you are off the hook for that month and you can repeat the process again. If you employ a rolling strategy of covered call writing, you can theoretically continue the process of collecting (generating) cash flow in the form of option premium to the point where all the premium collected has offset the original cost of the stock. It’s a great way to supplement your income and there are lots of savvy investors out there doing it everyday.

Good luck,

Lee