Objective-first construction of hedges and income

Name the objective first

An options construction is selected after a specific objective is named. A generic desire to profit does not identify which structure to use.

That rule is objective-first construction: choosing an options structure only after naming the portfolio job it must perform.

Four common jobs

Common options jobs fall into four groups: stating a directional view, hedging a holding or book, generating income, and using neutral or unusual market conditions.

State a directional view

A long call or put can state a directional view while committing less capital than buying the equivalent shares. The premium paid is the defined maximum loss on that option.

That cash outlay is defined-premium-risk: the cash paid for a long option, which is the most that long-option construction can lose.

Bound a holding or a book

A protective put on a held stock offsets declines below its strike on a one-for-one basis through expiration, bounding downside without selling the shares. A protective put is a long put held against a stock or index so declines beyond the strike are offset for the life of the option.

A put on a broad equity index can offset some or all of a portfolio-wide decline while the underlying holdings stay in place. That construction is an index put overlay: a put on a broad equity index used to offset a book-wide decline without selling the underlying holdings.

Premium collection as the named job

An option income strategy is a premium-collecting construction, typically a covered call or credit spread, that keeps the credit if price stays inside the sold strike.

Writing a covered call against stock already held retains the collected premium if the share price stays below the sold strike. A covered call is a short call written against shares already owned. The writer keeps the premium if the stock remains below the call strike.

A credit spread is built by selling an out-of-the-money call or put and buying a further out-of-the-money option of the same type, receiving the price difference as a net credit. If the underlying stays on the favorable side of the sold strike, the credit-spread construction keeps that entire net credit.

An option spread is a paired long and short option of the same type that fixes the net credit or debit and the maximum loss at entry. A credit spread is that pair when the nearer out-of-the-money option is sold and the farther one is bought.