Question

Briefly discuss the importance of the options market and purposes that they serve in the market. List and discuss one pro and one con about these speculative strategies using a real-world example. Protective puts and covered calls are widely used hedging strategies. Give a real example of how and why you would use these two strategies along with an advantage and disadvantage of each.

Answer 1

The options market help us in hedging our positions and provide the much-needed risk management which the stock market alone can't provide. They are very useful for professions like importers, exporters, farmers etc because they help them achieve a steady stream of cash without worrying about the change in market variables in the future. One advantage of speculative strategies is that it makes markets for those who would like to actually perform hedging or risk management. One disadvantage is that it leads to speculative behaviour among financial institutions and professionals which can lead to dangerous consequences. For e.g. the downfall of Bearings Bank was due to one such trader in the firm going rogue and using his position in the company to hide his loss-making trades which led to the collapse of the bank in the end.

A protective put is a risk management and options strategy that involves holding a long position in the underlying asset (e.g., stock) and purchasing a put option with a strike price. A covered call is when we have the underlying and we take a short position in the call option. Hence, we see that both of these strategies involve the underlying. In other words, even if the price of the put or the call option were to go against us, we have the underlying which protects us from having a loss. The advantage of these strategies is that there is only upside for us and we don't have to worry about the downside. The disadvantage of these strategies is that we have to pay the option premium which makes the strategy slightly expensive to execute.