Curatia Analysis for Thu, Apr 9

Options 101: Using Options to Meet Diverse Trading Objectives

Kevin Davitt Head, Index Options Content, Nasdaq

Options are flexible financial tools that let traders pursue goals ranging from protecting an investment to seeking higher returns. In part because options require only a relatively small upfront payment compared with buying or selling the underlying asset, investors can use them to shape risk-reward dynamics in diverse ways.

Hedging: Protecting an Existing Investment

Many traders use options to hedge, or reduce the risk of losses in a position they already hold. In this context, options act much like insurance.

A common example is the protective put. A put option gives its owner the right to sell the underlying asset at the strike price on or before the option’s expiration date. If an investor owns a stock but worries it might decline in the short term, buying a put can limit potential losses. If the stock falls below the strike price, the put may gain value, helping offset the decline in the stock.

Calls can also play a role in hedging. For instance, a trader who has sold a stock short (meaning they benefit if the stock falls) might buy a call option — which gives the right to buy the stock at a set price — to limit losses if the stock rises unexpectedly.

Hedging strategies are widely used by both individual and institutional investors. In markets like the Nasdaq-100 Index®, investors sometimes use options on indexes or ETFs that track the index to hedge exposure to a broader market rather than a single stock.

Generating Income

Options can also be used to generate income, especially from stocks or ETFs an investor already owns.

One way to do so is with a covered call. In this strategy, an investor who owns a stock sells a call option on that stock. If the stock stays below the option’s strike price until expiration, the option expires worthless, and the seller keeps the premium as income.

The trade-off is that the investor may have to sell the stock if its price rises above the option’s strike price. In other words, covered calls exchange some potential upside for immediate income.

An uncovered option (also called a “naked option”), by contrast, is one in which the seller of the option contract lacks a position in its underlying asset. The seller would thus have to quickly acquire the underlying asset if the buyer wishes to exercise the option. That possibility increases the seller’s risk.

Income strategies can also involve selling put options. In this case, the trader receives a premium in exchange for agreeing to buy a stock at the strike price if the option buyer exercises the contract. Some investors use this strategy when they are willing to buy a stock at a lower price and want to potentially generate income while waiting.

Speculation: Seeking Higher Returns

Some traders use options to speculate, or try to profit from expected price movements.

Options can make speculation attractive because they offer leverage. Leverage means a relatively small amount of money can control a much larger amount of the underlying asset.

For example, one standard equity options contract typically represents 100 shares of the underlying stock. Buying 100 shares of a $100 stock would require $10,000. But a call option on that same stock might cost only a few hundred dollars.

If the stock rises sharply, the option’s value could increase significantly relative to its purchase price. If the stock falls, on the other hand, a trader can let the contract expire worthless, losing only the option premium.

When selling options, though, leverage can magnify losses. Selling a put option could later require a trader to purchase the option’s underlying asset. If the price of that asset falls to $0, the trader could lose the entire value of the asset, minus the option premium collected.

Selling an uncovered call option meanwhile exposes an investor to a theoretically uncapped loss, since there is no limit to how high an asset’s price can go.

Speculation with options thus involves meaningful risk and requires careful planning.

Measuring & Managing Risk

Since options are sensitive to numerous factors, traders often rely on a set of measures known as the option Greeks (named in reference to letters in the Greek alphabet) to understand and manage risk. Each Greek represents a variable that describes how an option’s theoretical value is expected to shift when certain conditions change.

• Delta, often considered the most important Greek, measures how much an option’s theoretical value moves when the price of its underlying asset changes. A delta of 0.50, for instance, suggests the option will move about $0.50 for every $1 move in its underlying asset. Delta also gauges the probability an option will be in the money (i.e., it has economic value) at expiration.


• Gamma measures how quickly delta itself changes when the underlying asset price moves. It helps traders understand how stable — or unstable — the option’s sensitivity to price changes may be. Gamma values are highest when an option is at the money and near expiration.


• Theta measures the effect of time decay, or the tendency for options to lose value as they approach expiration. Just as a trailing sports team’s odds to win a game decline as time runs out, time decay typically accelerates as expiration approaches.


• Vega measures how sensitive an option’s price is to changes in implied volatility, or how much the market expects the underlying asset’s price to fluctuate. Option premiums rise as volatility increases, boosting the odds an option will end up in the money.


• Rho measures an option’s price sensitivity to changes in interest rates. Rho is a “minor Greek” — a collection of subtler risk factors increasingly used in electronic trading.

Options can serve many different purposes, from protecting a portfolio to generating income or pursuing higher returns. Understanding how these strategies work, and how risk is measured through tools like the Greeks, can help traders decide whether options fit their investment goals.

Next we’ll examine the types of strategies that have become popular for using options to meet these trading objectives.