Investment Strategies - Hedging and Options Strategies
Options may be combined in a myriad of ways to produce risk/return profiles to hedge or speculate according to the investor's needs and circumstances within the context of the current market environment. We shall touch on some of the most common ones here.
- Straddle - The combination of a put and call with the same exercise price and expiration date. It may be long (both options are purchased) or short (both options are written). The former would be profitable if the underlying increased or decreased enough to cover the option premia. The maximum loss on a long straddle is the premia paid. The latter would benefit the investor if the underlying were not volatile during the option contract period. The maximum gain here would be the premia collected. Losses could be unlimited, making such a strategy often imprudent.
- Strips - A straddle where the investor holds two calls and one put, making it bullish.
- Straps - The investor is long two puts and one call, making this approach bearish.
- Strangles - Similar to a straddle, but the options have different strike prices. The strategy costs less as the options comprising it are purchased out of the money.
- Spread - he simultaneous purchase and sale of options of the same class.
- Call spread - the investor is long a call and short a call.
- Put spread - the investor is long a put and short a put.
- Costless Collar - this approach is used to protect a gain in a long stock position. It consists of a long stock position, long put position and short call position. The sale of the call finances the cost of the put, hence the term costless or zero-cost. The strategy protects the long position against downside risk.
- Net Unrealized Appreciation (NUA) - Investors with company stock in a qualified retirement plan have the option of taking shares payable to them in-kind. The tax advantage to the participant is that they pay ordinary income tax only on the basis and receive immediate long-term capital gains treatment without having to satisfy any holding period requirements.
- Asset Selection-tax deferred accounts would be a more appropriate place for any income producing investments, due to the tax-deferral feature. Municipal securities would be excluded as their yield is tax-exempt. In practice, some balance between income producing securities and those generating longer term capital gains would be more appropriate. The client's goals are critical.