Options are probably one of the most misunderstood financial products in existence. Popular press and news have highlighted rogue traders losing billions on market bets. While options can be used to speculate on market direction and if managed improperly, can produce large losses, their original intent is to lower or hedge risk.
There are three basis uses for options – speculation, risk management and income generation. Let’s take a look at each one of these. First, options can be used to speculate about a market move. We can buy an option for a relatively small amount of money and bet on the expected behavior of the market. And since options are highly leveraged products, we can place a relatively large bet with a small amount of money. But like a double edged sword, while the returns can be tremendous the losses can be just as big if not managed properly.
Options were originally developed for risk management and that continues to be a popular use today. For example, if you own a home or a car and have insurance, you probably own something like an option. That insurance policy you pay a premium for every 6 months or so protects you by paying you if your car or house gets damaged. The insurance policy acts to manage your risk of total loss of property. Options can act in the same way for stocks, futures or indexes. They can protect us from the downside (would have been nice in 2008).
In addition to managing risk and speculation, options can be used to create income. Options are what we call a “decaying asset”. Since all options expire at a specific date, some of the value of the option will diminish with time. There are ways in which traders and investors are able to profit from this characteristic using specific strategies. We at Terrapin take advantage of these characteristics in providing additional income to client portfolios on a monthly basis.
Used properly options can be a powerful tool for investors. However, like all tools, without proper knowledge the user can get hurt. Let us at Terrapin Capital put our experience to work and show you how our risk management and income enhancement strategies can help you achieve your investment goals.
