Besides buying or selling single options, there are many other possible strategies that involve positions in multiple options simultaneously, as well as combining options with positions in the underlying assets. While there are infinite combinations possible, we start with two common combinations below.
A protective put is a strategy that can be used to insure a stock portfolio against losses. The investor combines a long position in the underlying asset with a long put option. The long put option position caps any potential loss caused by a drop in the share price, as the investor will be able to exercise the put option at the strike price and lock in the sell price, only losing the premium paid.
A covered call is constructed by combining a long position in the underlying asset with writing a call option against the same asset. By selling the call option, the investor receives an option premium. This guaranteed income offers a small downside protection; if a decline in the underlying price is lower than or equal to the amount of option premium received, the total position does not return a loss. In return, the investor caps the profit potential by agreeing to sell the shares at the strike price. As such, this strategy works well if the investor expects little change in the price of the underlying asset or has determined an exit level for their investment at which they are happy to sell
What is an ETF? An ETF – or exchange traded fund – is a fund formed by a basket of underlying instruments that can be traded on the exchange. ETFs are often (but not always) tracking an index and following the index methodology, providing investors a low-cost and efficient way to invest in an index without having to buy all the underlying constituents.
The Option Greeks are a collection of variables that measure the sensitivity of option prices to changes in underlying factors. Mathematically, they are derivatives of components of option pricing models. Each factor has a Greek letter assigned to it, hence the name ‘Greeks’.
The Options Basics Explainer introduced the concepts of call and put options, strike price, expiry, and long or short positions in an option contract. This page looks in more detail at option pricing.
What are derivatives? Derivatives are financial instruments that derive their price from an underlying asset. The most common types of derivatives are futures, forwards, options, and swaps. A derivative is a contract between a seller(s) and buyer(s), where the price and value of the contract depends on the price and price movements of the underlying asset. The most common types of underlying are shares, indices, commodities, interest rates, currencies and bonds. Derivatives are commonly used for hedging purposes. Hedging is a form of reducing or eliminating the risk of adverse price movements, which can be regarded a form of insurance.
What is market making? A market maker, also called a liquidity provider, is a firm or individual that continuously provides quotes – both bids to buy and offers to sell – for a given financial instrument, as a primary trading strategy. A market maker is generally contractually and/or legally obligated to provide quotes for set period of a trading day for a minimum size and for a maximum bid-ask spread. The market maker provides liquidity and improves the functioning of the market by making the process of finding a counterparty to trade with more efficient while also bringing down the cost of trading.
What are options? An option is a type of derivative contract that gives the holder the right to buy or sell the underlying asset at a predetermined price – the exercise or strike price – at or before a certain date. Options exist on a wide variety of underlying assets, like single stocks, indices, ETFs, bonds, currencies, commodities. These contracts can serve as tools to protect a portfolio against potential losses or to express an opinion about the direction of the market.
