During periods of high volatility, as part of a prudent risk management strategy, or as a speculative, directional neutral transaction, options are a very valuable supplement to any investment portfolio.
After traders conduct due diligence and establish positions, no matter how certain they are about the direction that volatile stocks will take, they are very limited by the ebb and flow of the market and its participants.Prudent traders may have risk management strategies in terms of portfolio diversification, strict stop-loss orders, etc. Keep track of their positions, or ask for an average drop (or rise) in case the stock goes against them.
However, these strategies have some important disadvantages: diversification may take up valuable funds from other ideas, stop-loss orders may be triggered shortly before the asset operates as originally expected, and average down/up may go wrong as the position continues to go wrong , Take excessive risks. Armed with knowledge of options, traders can expand their risk management tool set and then increase the return potential of their positions.
Synthetic stock position
One of the main ways that options can reduce risk is through their inherent leverage nature.The savvy option trader can go one step further and create synthetic Long and short stocks The choice of position is completely compromised. By doing long at parity call options and writing parity put options, option traders can simulate long stock positions. In addition, by writing a put option to offset the premium of the call option, the transaction can be carried out with little or no initial cost.
As the underlying stock rises, the value of the call option increases. If the underlying stock plummets, the value of the short sale will increase. Therefore, the trader will bear downside losses, just like an actual long stock position. Conversely, when a trader buys a put option and sells a call option, a synthetic short position will be initiated.
During periods of volatility, the advantage of synthetic stock positions is that they can control a large number of stocks with almost no capital occupation, thereby allowing traders with even small accounts to take diversification measures. In addition, synthetic positions provide greater flexibility to exit positions by purchasing comparative options: put options on long stocks and call options on short stock positions, rather than having to pursue average down/ups. Finally, there is an additional benefit of comprehensively shorting stocks, which allows traders to short stocks that are difficult to borrow without having to worry about borrowing costs and being unaffected by dividend payments.
Options can also be used to protect existing stock positions from adverse fluctuations. The simplest and most commonly used option strategies are protective puts (long stock positions) and protective call short positions.
Let’s take a look at a stock known for its volatility: Tesla Motors (TSLA). In early March 2015, the stock was trading in the range of US$185-187. Bullish traders can do more at this position, hoping to quickly rise to the level of US$224, and buy at the price of US$8.05 or US$805. April 17 The expiration of $190 to exercise the put option.Therefore, traders will be fully aware of the maximum loss that may occur in the transaction from the date of purchase to the expiration of the option, that is, the premium of the put option plus the distance from the strike price of the put option to the entry price.
As of mid-March 2015, Tesla’s closing price was US$193.74, so this would be the largest loss per share of US$11.79 or approximately 6% loss per 100 shares worth US$19,374.In other words, from now until April 17, no matter how far Tesla plummets after breaking through the support level, traders can always exercise options to sell their shares at the strike price at expiration-even if Tesla falls low The strike price may fall all the way to zero at US$1.
In addition, if traders have already received position gains, and with volatility imminent, such as the days before Tesla’s Model D, traders can use part of their profits to lock in their gains. Gain income by purchasing protective put options. The disadvantage of this strategy is that stocks need to move in the expected direction, and option premiums need to break even. If there is no such change in the stock between now and the option expiration, due to the destruction of time decay (theta), the put option may expire at zero dollars and never exercised.
In order to deal with potential premium losses, traders can write reverse options to protected put or call options at the same time. This strategy is called a collar, and it can reduce the premium of protective options at the expense of setting a ceiling on future returns. However, the collar is an advanced strategy that is beyond the scope of this article.
Perhaps the most advantageous feature of options relative to pure stock positions is the ability to adopt a direction-neutral strategy, which can make money no matter where the stock goes. When an extremely unpredictable moment is approaching, such as an earnings report, stock traders are limited to directional bets dominated by the market.
However, option traders will meet this impending volatility through long strides and strangulation. Straddle options are simply the purchase of at-the-money call options and flat put options with the same strike price and expiry date. If the trader expects significant fluctuations in either direction in the near future, this is a net debit transaction. By checking historical volatility and implied volatility (IV) and predicting that the IV will be higher in the future (for example, when the earnings report date approaches), traders can enter a straddle position and fully understand that the biggest loss they may suffer is the net premium They pay for combined options.
On the contrary, if traders believe that the level of volatility is too high and the option price is moderate, and then the stock will not fluctuate as expected by the market in the near future, they can sell straddle or stifle. This phenomenon is called “IV crowding”. Pressure”. Directional neutrality may be the largest weapon in the option trader’s arsenal, and it is the basis for more advanced strategies (such as butterfly, condor, and delta neutral trading). Due to the contradiction of direction, traders admit that the market is random and position themselves as both a bull market and a bear market to make money.
Options provide a low level of capital expenditures, a large number of directional biased or neutral strategies, and excellent risk management features. Although there is nothing wrong with trading pure stock portfolios, by understanding options and their characteristics, traders can add more tools to their arsenal and increase their chances of success in times of market turmoil and docility.