Options are one of the most versatile financial instruments available to investors today.
Like any other investment vehicle, there are times when the use of options may be appropriate and times when one might be better served taking a position in the underlying instrument.
When it comes to the best time to buy options, there are times when it can make a whole lot of sense and times when it will stack the deck against you.
Here we will discuss three potential scenarios in which going long premium might be warranted:
- Implied volatility is at the low end of the range: An options value can be largely influenced by changes in implied volatility. When options are trading at higher levels of IV, they may be considered relatively expensive. On the other hand, when options are trading at lower levels of IV, they may be considered relatively cheap. If you are expecting a big move in a market and if IV levels are near the bottom end of their six-month of 12-month range, buying options might potentially be a good way to go.
- You have a position you’d like to hedge: Suppose you own 1000 shares of stock ABC. The company will be reporting earnings soon and while you feel the stock price will go higher, you are also worried about potential selling and lower prices. One way to hedge your position would be through the purchase of put options. A put gives you the right, but not the obligation, to sell your shares at a certain price. For example, if ABC is currently at $50 per share and you buy the $47 puts, even if the stock price tumbled to $45 per share you would still have the right to receive $47 per share. Of course, options cost many and if the options expire worthless the premium paid will be lost.
- You expect a large move, but don’t know in which direction: Suppose the Federal Reserve has an upcoming announcement on interest rates and monetary policy. You feel that bond and note prices could see a huge move, but are unsure in which direction. In such a case, you could consider buying a straddle or strangle using both calls and puts. This type of position has defined risk (the total premium paid) and has unlimited profit potential. The position can potentially profit with a market move in either direction although a very substantial move may be required to overcome time decay and a possible decline in IV.
When it comes to buying options, long calls and puts can provide defined risk and the potential for unlimited profits depending on position structure. That being said, trading is a game of odds and as such you always want to try to put the odds in your favor. Buying options under the right conditions can potentially help tilt the scales in your favor.
