Option Writes for Hedging Stocks
Trading the financial markets is notorious for its difficulty. Clichs to describe that difficulty are abundant:
"Whatever your weakness, the market will find it."
"The smartest minds end up at the market."
"Most traders have written more cheques to their broker than they've received."
And, of course:
"Most option trades expire worthless."
The majority of negative conceptions surrounding the markets' difficulty focus on the impossibility of seeing the future. Based on that, most in the mainstream have another clich, about how it's impossible to time the markets. Yet many successful traders seem to agree that trading well has little to do with prediction. Directionality is only one facet of market movement. Indeed, one of the fascinating characteristics about how markets trade is their ability to conceal their longer-term direction through countertrend shorter-term moves. A market under distribution can often stage spectacular rallies within its downtrend, just as markets can take jarring corrections as they rally higher.
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How can options help traders to profit from these unpredictable, elusive markets? The clich about how most option trades expire worthless (one variation adds that most option traders expire worthless as well) provides a constant on which successful trades can be leveraged.
Stock options are the right to sell or buy an underlying stock at a fixed price for a fixed period of time. They are now traded not just on stocks but also on indices and exchange-traded funds (ETFs), not to mention options on futures and other securities. Some option markets are very deep and liquid, with tight spreads and predictable executions, making them accessible even to small and part-time investors. Options can be bought by traders seeking to profit from an underlying stock's or security's rise in price ("call" options) or a fall in price ("put" options). They can also be sold short, which is the focus of our current discussion.
Option prices are based on the combination of an intrinsic value and a time value, also referred to as "premium." The degree to which an option is "in-the-money" is its intrinsic value, while the difference between its actual price and that intrinsic value is the premium. Generally, the premium increases the longer a particular option contract has to expiration. At-the-money or out-of-the-money options that have many months or years remaining to expiry will always have a higher premium than options with only a few days or weeks remaining, and that premium shrinks as expiration draws nearer. On expiration day, the premium on an option contract should be zero, or very close to it.
By selling that dwindling premium, an option trader can help stack the odds in her favor, as option premium shrinks with the forward march of time. Better yet, the same strategy can be used selectively to hedge existing positions, regardless of market direction. When the existing position being hedged is an option position, the hedge creates a "spread." When the position is a stock position, the hedge creates a "covered write."