Options provide leverage and limited risk, allowing traders to gain exposure to assets and manage risk.
Options can be used as a hedging tool to protect against potential losses in portfolios.
Options allow traders to take a view on factors beyond just the direction of the underlying asset, including volatility and time value.
Deep dives
Options provide leverage and risk management
Options offer the advantage of providing leverage while limiting risk. Traders can gain exposure to an asset with a small amount of capital, known as the premium. If the option moves in their favor, they can profit, and the maximum loss is limited to the premium paid. This safe leverage allows traders to take a directional view on an asset while managing their risk.
Options can be used for hedging
Options serve as a hedging tool for investors. Instead of exiting existing exposures, investors can use options to protect against potential losses in their portfolio. By purchasing put options, they have the right, but not the obligation, to sell an asset at a specific price. If the market declines, the put options appreciate in value, effectively offsetting losses in the portfolio.
Options provide exposure to volatility and time value
Options offer the ability to take a view on factors beyond just the direction of the underlying asset. Traders can trade volatility through options by taking a view on changes in implied volatility. Options also have time value, which reflects the amount that the option's price can change due to the passage of time. The duration of the option affects its time value, with longer-dated options having more time value.
Understanding Leverage and Risk in Options Trading
Options trading offers leverage and the potential for high returns, but also comes with significant risks. The more out of the money and short-dated an option is, the more leverage it provides. However, options can quickly become worthless if the underlying stock doesn't move in the desired direction. It's crucial to consider factors such as the likelihood of the stock reaching a specific price and the time decay of options when assessing their leverage ratio. While options provide opportunities for profit, they also present situations where even correct predictions may not yield returns due to slow stock movements or low intrinsic value.
Understanding Protective Puts and the Trade-offs of Put Spreads
Investors often consider protective puts to hedge their portfolios. They can choose from various strikes and deltas based on their desired level of protection and exposure neutralization. Buying out of the money puts can provide crash protection, but may not offer gains in smaller market downturns. However, put spreads offer a cheaper alternative by buying a put and simultaneously selling a put with a lower strike. While put spreads limit the upside potential and may be challenging to monetize compared to outright puts, they offer a balance between cost efficiency and crash protection. The trade-off lies in the potential profit and flexibility of outright puts compared to the specific zonal profit that put spreads provide.
In today's episode of Forward Guidance, class is back in session with Imran Lakha as the attending professor. Going through the basics of options, Lakha turns his attentions not only to the absolute fundamentals, but to the whys and hows of options, explaining their use, what can affect them, and when and where they should not be used. Not only is this a perfunctory lesson in options but a deeper dive into their function into the economic world for beginners and masters alike of the macro trade.
Lakha on Twitter: @options_insight
Farley on Twitter: @JackFarley96
Blockworks on Twitter: @Blockworks_
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