There are three main players in the market who use options in there trading strategies: hedgers, speculators and arbitrageurs.

Protective Put is the most common instrument of the hedgers. It is generally used to hedge the risk of decrease in the stock price.

An investor purchases a Protective Put while holding a portfolio of shares from the underlying stock, fixing the minimum value of holding in case of decline in the stock price.

The graph below represents the relation between the value of holding and the stock price. The solid line stands for the hedged position and the dotted one – for no hedging.

Example 1:

Portfolio: 1000 shares of Microsoft

Current stock price: $28

Two-month put option price: $1

Strike price: $27.50

Investor wants to protect the value

No hedging

2) Second alternative:

Hedging

Price goes up:

Profit = ($35 — $28)*1000 = $7000

Profit = ($35 — $28)*1000 — $1000 = $6000

Price goes down:

Loss = ($21 — $28)*1000 = -$7000

Loss = ($27.50 — $28)*1000 — $1000 = -$1500

The market opinion of an investor is still bullish on the underlying stock but he limits his loss to the cost of option strategy plus possible difference between spot and strike prices. Profits remain unlimited and are positively correlated with the stock price.

Covered Call – writing a call option while holding a portfolio of shares from the underlying stock. This instrument is widely used when an investor believes that the market value will be more or less stable until the date of call maturity date.

The graph on the right represents two situations. Red line – is a simple holding a portfolio of shares. Blue line stands for issuing a covered call.

Covered call protects an investor from small decline in the stock price (because he will still collect the call premium). But further decline in market price will lead to a substantial loss.

So, the protection against stock price decline is limited.

The covered call strategy is often described as “conservative” because an investor collects call premium, possible dividends from stock but withdraw potential profits if the market price will rise substantially. So, the market opinion here is neutral to bullish. Profits are limited.

Protective Puts and Covered Calls are the most common hedging strategies against undesirable price fluctuations.

There are some other options strategies which employ more sophisticated tools.

Collar is a combination of Protective Put and Covered Call. Establishing a collar position involves three components: holding the portfolio of underlying stock, buying a put (on this stock) and writing a call. The cost of downside put protection in a collar is smaller than in a standard protective put. Depending on the maturity and expiration prices, establishing a collar can even bring a net cash profit (if call premium exceeds put option price).

The graph on the right draws a comparison between collar (blue line) and simple holding a portfolio of shares (red line).

Spreads

Spreads are useful in a moderately bearish or moderately bullish environment.

The graph for a bullish spread looks similar to collar but the concepts here a different. A collar combines long call and short put, while a bullish spread combines long call and short call (at a higher exercise price).

Speculation, as the name suggests, is a much more risky and volatile strategy. Speculative use of options can produce a great return for an investor or become a total loss. In order to speculate on stocks successfully, an investor must correctly estimate several variables: movement of the price of a stock, how much the price of a stock will go up or down, amount of time it will take for the stock to go up or down, cost of the options strategy. Once again, the concept of speculation is clearly seen from the example below.

Example 2:

Willing to invest: $2000

Current price: $20

Two-month call option price: $1

Strike price: $22.50

Investor expects share price to rise