by Wendy Kirkland

Hedge Against Loss

Options are often used as a way to hedge against losses on the equity shares that an investor owns. If the overall market is going through a correction period and is heading down or if the equity has received some bad news and looks like it will pullback for a short period of time, the investor often would like to purchase a put option as protection.

A put option increases in value as the equity price drops. This way as the price of the equity drops, the price of the put increases and offsets a portion of the equity’s loss.

Until Mini-Options came along, if an investor owns 30 shares of Apple, Inc.’s (AAPL) stock, he had to purchase a put contract that covered 100 shares of Apple’s stock. This tied up 3+ times the money actually needed to protect the shares he owned, but also increased the risk more than 3 times if the put option was to be exercised at expiration.

Covered Calls

Another technique that investors use as an income source is to sell options against the stocks they own. If an investor owns 55 shares of Amazon (AMZN), and wants to earn a monthly income from those shares, he might sell a call option against them and the premium for that option would be added to his account.

Again, the call option would cover 100 shares, which he only had 55 shares to cover the option. The other 45 shares on the option would be considered naked since he didn’t own them.

If the call was exercised, he would need to purchase those 45 shares from his account to cover the call option. This would require an additional margin or locked up funds to make sure he could honor that purchase obligation.

Selling a Portion of Your Options

The typical investment strategy often involves simply “buying Options on ABC stock, holding Option ABC, and then selling Option ABC for a profit.” This is wonderful buy and hold strategy if the price heads up in the case of call options or down in the case of put options and the investor wants to sit through all the price swings.

But an experienced trader knows there are other possibilities…

The most common ways to implement selling a portion of a position into an investment strategy include:

  • Selling a portion (often 1/3 to 1/2) to take profits off the table.
  • Selling a portion to minimize downside risk (losing unrealized gains).
  • Selling a portion to minimize risk while taking profits off the table.
  • Selling a portion to take profits off the table, then re-buying the shares at a more
    competitive price.

Selling to Take Profits

Especially useful for newer traders who are constantly combating trading-emotions, selling half a position simply to take some money off the table can be a very smart play.

Minimize Downside Risk

Seasoned traders know that calculating risk is a huge piece of the puzzle when it comes to trading successfully online. A very simple way to lower risk with a losing option that may yet go up comes with selling a portion of the position flat out to decrease the continued loss potential.

Minimize Risk and Take Profits

Hypothetically let’s say an investor is in an option that just surged 10% in a single day and hit all time price highs. With very substantial unrealized gains now in the portfolio, by selling a portion of the position, the investor can seal in some profits and lower overall exposure (minimize risk). A double edged sword as he cuts more upside potential on the portion sold as he reduces risk.

Take Profits, Re-buy at a Lower Price

A seasoned trader knows and understands how their long-term option positions can fluctuate in price while still remaining in a general uptrend/downtrend. Just like watching the waves ebb and flow off a beach, by watching an option over time traders can get a read on the overall price patterns. If they suspect a short-term correction is around the corner but still want to maintain a portion of their position, they can sell a portion and look to re-buy if the equity drops to help gain some extra profits.

Cost versus Benefits

With Standard Options, if you own just one contract of one of these expensive equities, you were forced to buy and hold that one contract until you decided to sell for any of the reasons listed above. You didn’t have the opportunity to sell only a portion of the 100 shares that the option covered.

Now you can purchase 10 Mini-Option contracts covering 100 shares of stock and then sell 4 contracts when they reached 25% profit, then another 3 contracts at a 50% gain, and let the last 3 ride until the equity changed directions.

A consideration to doing this is you will increase the trade fees. There will be a fee each time you close a trade. Therefore, you must consider this cost when you decide to close the contracts in incremental sales.