Are You A Hedger Or A Speculator?

Do you welcome risk or run from it? The answer to this question will determine which options strategies might work for you.

If you welcome risk, then you are a speculator. Speculators use “naked” options which allow the holder to profit when prices move in one direction. Below you will find some strategies based on your beliefs about the underlying stock’s future direction.

Photo by Morning Magician, courtesy of flickr

Stock is going up: buy a call option or write a put option.

If you bought a call option and your speculation turned out to be correct, then you would profit from buying the stock at a discount to its market value.

If you wrote a put option, you would collect a premium up-front from the put option’s buyer. If the stock’s price went up, then the buyer would not exercise the option and you would keep the premium.

Stock is going down: write a call option or buy a put option.

By writing a call option, you collect a premium from the call’s buyer. If prices go down, the call’s buyer would not exercise the option and you would keep the premium. If you were to buy a put, then a price decrease would allow you to sell the stock at above market value.

If you want to reduce risk, then you are a hedger and the strategies below could help you alleviate some risk.

Covered call – A covered call entails writing a call option on a stock that you already own. By owning the stock, you profit if the stock price rises. By writing a call option, you collect the option’s premium from the option’s buyer. If prices go down, the buyer will not exercise the option and the premium is yours to keep.

Protective put – A protective put includes buying a put option on a stock that you already own. By owning the stock, you profit if the stock price rises. Buying a put would allow you to profit if the price of the stock went down, but you will have to pay the premium for the put option at the contract’s inception.

Hedgers and speculators are both needed for derivatives markets to function. Speculators assume risk in hopes of high returns, while hedgers are willing to accept potentially lower returns in exchange for risk reduction.

If you’re still trying to figure out how comfortable you are with risk, visit kiplinger.com and find your risk tolerance.