Other than speculation,
options can also be bought as a means to insure potential losses for an
existing position in the underlying. To hedge a long underlying position, a protective put can be purchased.
Similarly, to protect a short underlying position, a protective call strategy can be
used.
In-the-money Covered Call Strategy
In-the-money covered call
options are sold when the investor has a neutral to slightly bearish
outlook towards the underlying security as their higher premiums provide
greater downside protection.
Out-of-the-money Covered Call Strategy
This is a covered call strategy where
the moderately bullish investor sells out-of-the-money calls against a holding of the underlying shares. The OTM covered
call is a popular strategy as the investor gets to collect premium while being
able to enjoy capital gains (albeit limited) if the underlying stock rallies.
Out-of-the-money options are cheaper to buy than in-the-money options but they are also more likely to expire worthless.
For call options, this means that the
higher the strike price, the cheaper the option. Similarly, put options with
lower strike prices are therefore less expensive to purchase.
However, the size of the premium alone
does not tell us the whole story. In fact, at-the-money options can be considered the most expensive even though their
premiums are lower than in-the-money options. This is because their time value is highest and time value is the part of the premium that
will waste away as the expiration date approaches.
