Options contracts can provide a buyer with an opportunity to buy stock for a significantly smaller price. Speculating is based on predicting a price direction in the future.
Some traders find speculating with call options to be a great opportunity because they can give leverage. If a speculator presumes the price of a stock will grow, they may use an out-of-the-money call option in order to obtain stocks at a lower price. We will illustrate this with an example.
Let’s say one contract is 100 shares of YX stock, and the current price is $100 per share. A call writer can give an option that one contract’s strike price is $2 and that it has one month till expiration. A speculator can use this leverage and buy 100 shares for a premium of $200 instead of spending $10,000. Controlling the same amount of stock bought at a much lower price gives the speculator the leverage.
Nevertheless, this is only lucrative if we predict the movement of the stock price correctly, as well as the magnitude of the price change. The time frame plays a great role as well. Depending on the trend of the stock, this could potentially provide huge gains. On the other hand, it could lead to premium loss of 100% if the prediction was wrong. This contributes to the fact that speculating is, in the end, risky.
Hedging was invented to protect the investor by reducing the risk. It is similar to paying insurance. If we pay a fixed amount every month to ensure our property, we only lose the known amount in case something happens. With hedging, the principle is the same.
Some might argue that if we feel like we need a hedge, we shouldn’t be investing at all. The practice has shown, however, there are benefits of such a precaution. If we buy stocks and use put options, we can protect ourselves against the downturn by limiting our downside risk. In case the prediction was wrong and a short squeeze occurs, short sellers can use call options to limit their loss.
Using an option called spread entails combining speculation with loss limiting through hedging. Spreads usually cost less; however, they can limit the potential upside.
A spread is an option that combines multiple options with similar features. That means we can buy one option and sell another option of the same class. We call it a vertical spread because the second option will be of the same type and have the same expiration date. However, they will differ in strikes.
Combinations are strategy options where we can take both the call and the put position of the same stock.
The combination trade known as ‘’synthetic’’ is very popular. The goal of this move is controlling the position of the assets without actually buying them. Taken that we have a stock YX we are interested in, we can use a combination strategy to create a synthetic long position in this stock.
Entering a synthetic trade would mean selling at-the-money put and purchasing at-the-money call that both have the same expiration and strike. However, this combination of a long call and short put doesn’t give us the ownership of the stock. Nevertheless, it influences the long position of it.
If there are reasons of legal or regulatory nature that restrict us from buying the stock, we can still use options to create a synthetic position. In addition, having an asset like an index that poses as difficult to recreate from individual components may call for this option.