Using Options for Risk Management
|•||Options can generate additional cash flow. The sale of covered calls provides additional cash flow. Of course, the writer of a covered call also hopes that the underlying asset price does not rise much above the strike price. Writing naked puts is a revenue-providing strategy that is used as a substitute for placing limit orders to buy an asset.|
|•||Options can be used to exploit tax-related situations. Writing a covered call as a substitute for the outright sale of the asset might defer a capital gain, or stretch a short-term gain into a long-term gain. Many other tax-driven strategies exist, but users should always obtain an opinion from tax accountants or tax attorneys before attempting to use options to reduce taxes.|
|•||Options provide leverage. Because the purchase of a call is equivalent to buying the underlying asset and borrowing, the leverage provided by options may exceed that available to many market participants who purchase only the underlying asset. The initial premium of an option is generally only a small fraction of the cost of buying the underlying asset.|
|•||Options can circumvent short selling difficulties. If an asset cannot be easily sold short, the purchase of a put may be the most efficient method for generating profits from a price decline in the underlying asset.|
An important question every risk manager faces is whether to buy options to insure against adverse price moves or to use forwards, futures, or swaps to hedge against price risks. Unfortunately, there is no easy answer to this question. However, here are some important considerations.