For individuals and for institutional investors whose mandates include the use of derivatives, options overlain on a stock position can boost returns on directional investments.
While long considered as the tools of speculators or “quants,” options are actually simple, directional instruments that have the potential to benefit the traditional value investor.
The first part of this article introduces options from the standpoint of the same sort of ranges of exposures with which stock investors are very familiar. Approached from this perspective, it is easy to see that options grant investors the same sort of exposure to directionality as stocks, but in a more flexible way.
The second part of this article discusses option pricing and leverage. Option pricing, while thought of as arcane and difficult, is actually based on an almost laughably simple model of stock price movement, which we explain visually. Options are not levered instruments, but many option strategies are typically implemented as levered ones. We explain what leverage is and how one should consider leverage in the context of options.