Options are widely considered as being something for only more experienced traders to deal in. This is largely due to the slightly more technical nature of their construction; things like expiry dates, exercise prices, terms such as Calls and Puts and also the one word that can form something of a mental block “derivatives”.
Traders putting money into the market should have the ability to get their heads around these concepts and once that is done it’s important to realize that Options can actually be used to manage risk rather than increase it.
Take for example a long position held in the equity AB InBev. Two ways to manage the downside risk associated with this position are stop-losses or the use of options.
Position of 10,000 bought for EUR 72.22
Current market price EUR 74.88
Trailing Stop loss set at 8% below current market price = 68.89
A flash crash is when the market has a momentary period of volatility but then trades back at previous levels. There is little consensus on reasons for them occurring, but the effects are considerable. During the crash of May 2010 the Dow Jones Index dropped 9 percent in minutes, but then quickly recovered. In our example the position would be closed near the stop, losses would be crystalized and having been kicked out of the position there would be no sharing in the profits associated with the recovery.
The pain could also be heightened if the stop instruction suffers slippage. In illiquid fast moving markets the order to sell that is triggered at 68.89 might not close out the entire position of 10,000 shares. The order to sell continues hitting the market price as it falls even lower and away from 68.89.
Buying Put options with a strike price of EUR 68.90 would cost a premium. But most importantly they would give you the option to sell at that price but not the obligation. In the case of a flash crash, a trader that waits for markets to recover will still have their long positions in equity and options.
Should the correction be permanent in nature then the trader can exercise the Puts, take the hit to P&L and move on.