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What are Stock Options and Hedging Strategies?

By Edited Jan 25, 2015 1 0
Buying Call Options
Credit: Etrade.com

If you have ever dabbled in the stock market, you have probably heard professional traders referring to options at length but dismissed them as too complicated for the novice investor. That does not have to be the case though because there are some basic stock option techniques that one can use to protect your gains or limit your loses.

First, you may be wondering what are stock options?

When you trade stocks, there are only two basic types of activities, buying or selling. However, trading in options can get a bit more complicated and confusing because of the complexity of some of the choices and combinations you have available to you.

For this basic discussion of how stock options work, we will focus on the 4 types of orders available for purchasing options:  

  • Buy To Open
  • Buy To Close
  • Sell To Open
  • Sell To Close

Exercising Stock Options

Market Orders

If you purchase an option order using a market order, you are filling the order at the first available price on the market regardless of prices. Typically, this is not advisable on option orders or individual stock orders because you are at the mercy to the market makers. You will not know what you are buying at until it is filled.

Limit Orders

If you elect to buy an option contract using a limit order, you are simply telling the market makers that you only want to purchase it at the specified price.  When using this tactic, there is the chance that you will miss out on the opportunity to buy at a recent price if the stock or options go on a run upward, but at least you will not be surprised by an out of the money purchase from a market order that you cannot control.

Other Frequently Used Terms

  • Long —implies a position of ownership of a stock or option
  • Short — selling a stock or option without actually own it with the understanding that at a later date you will have to cover (buy it back) that short
  • Strike Price — the agreed upon price per share on an option contract at which the stock can be purchased or sold during the contract
  • Out-of-the-Money - buying a call option where the current stock price is below the strike price. If purchasing a put option, the stock price is above the strike price
  • In-The-Money  - buying a call option where the current stock price is above the strike price
  • At-The-Money – when the stock price is equal to the strike price
  • Exercise —when the option owner buys or sells the underlying stock at the strike price
  • Stop-Loss Order - an order to sell a stock or option when it reaches a certain price to limit an exposure to a loss


How to Trade Options
Credit: Etrade.com

Buy To Open

This the most common type of option order. When you buy an open option, you are opening a position through buying a contract to go long a stock.

When To Use Buy To Open

If you expect a stock to appreciate in price over a certain length of time, whether several weeks in the future, or months to up to 2 years for some stocks, you can open a contract to have the option to buy that stock at a given price during the length of the contract.

What is Buy to Open?

When you open a position, you can either go long or go short.  The contract you buy is fulfilled by a market maker and kept in your trading account until you sell the option (close it out) or until it expires.

An open buy order can be filled immediately if you select market price, or you can specify a price to buy it at called a limit price.

There are two main types of Buy to Open orders

  • Call Option - If you expect a stock to rise over a certain period of time, you would use a buy to open call option. Owning this type of option for a selected period of time gives you the right to exercise the option (or stock appreciation rights) anytime you want during the length of the option contract until the expiration date.
  •  Put Option – If you expect a stock to go down over a certain period of time, a put options allows you to own those contracts during the option length at any time at the specified strike price until they expire.

Sell To Close

This type of order means that you are closing a position or exercising stock options by selling the contracts that you own.

When To Use Sell To Close

You would “Sell To Close” a call or put option to close it out at the end of the contract or at any time during the period specified by the contract.

What Does Sell To Close Mean?

This type of option action simply means you are closing a position. You can think of it in the same way as selling individual stock. 

When you sell to close call or put options, you are taking whatever profits or loses you have at that specific time. At that point, you relinquish your ownership of those contracts and you will no longer benefit from further appreciation in their value nor suffer further losses if the stock went down.

Sell to Open

This type of order is less common because it can be more risky and should only be attempted by experience traders. With this type of order, you are opening a position by selling option contracts, essentially short selling the stock.  You are betting the stock will depreciate within a given period of time.

When To Use Sell To Open

When you think a stock is going to depreciate, you would use this type of order.

What Does Sell To Open Mean?

When you open a contract to sell to open, you are shorting a particular stock by purchasing options to buy it at the agreed upon strike price and selling them to a market maker.

Sell To Open Call Options

If you think the direction of a stock is trending down, you could sell to open a call option. In effect, you are shorting the stock placing you under the obligation to sell the stock to a holder if the contracts are exercised.

Sell To Open Put Options

If you think the direction of a stock is trending up, you could sell to open a put option. Basically, you are selling a put option to market makers who are speculating that the underlying stock within the contract is going down.  You are under the obligation to buy that stock from the holder when they exercise the options.

Buy To Close

Buying to close simply means you are closing a position by buying a contract you previously sold short.  

When To Use Buy To Close

Buy to close orders are used to close or trade out of a short position at any time before the contract expires.

What Does Buy To Close Mean?

You are closing a position that you previously held short by buying the contracts back, essentially the same thing you would do if you sold individual stocks short.  At that point you will realize whatever loss or gain in your account.

Buy To Close Call Options and Put Options

You would buy to close call options and put options if you wanted to take profits or stop a loss on contracts you previously wrote.  When exercised, this resolves you of any obligation under the contract.


Trading Options in the Market
Credit: Opensource

If you are reading this article, chances are you are a novice trader that has never traded in options and wants to learn as much as possible before giving it a try. Using these strategies are a good way to speculate if you think a stock is going up or down, but also controlling or limiting your downside risk.

However, when starting out, it is best to stick with Call Option using limit orders. You purchase a stock at an agreed upon price with a certain strike price that is good for a specified amount of time, which dictates how long you can exercise the option before it expires.  

For your first trade, do not buy at the market price and set your limit price at least 10% lower than the current market option offerings with a three to six month expiration date.  After getting your feet wet, you can experiment with more complicated combination trades.



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