Options 101: Introduction
Options are powerful tools for investors seeking risk management, income generation, and portfolio diversification. This guide explains:
– What options are and how they work.
– The benefits and risks of using options.
– Common strategies like covered calls, puts, and collars.
– How options fit into a portfolio alongside stocks and bonds.
Key Takeaway: An option is a contract that gives you the right—but not the obligation—to buy or sell a security at a set price at a certain future time, offering both opportunity and defense when used correctly.
An option is a contract that gives you the right—but not the obligation—to buy or sell a specified amount of an underlying security—like a stock or ETF—at a specified price (the strike price) before a certain date (the expiration date). There are two basic types:
Key Terms:
Call Option: Right to buy at the strike price.
Put Option: Right to sell at the strike price.
Premium: Price paid for the option.
Strike Price: The agreed price to buy/sell.
Expiration Date: When the contract ends.
Options can be used in multiple ways—using either calls or puts, or in various combinations—to seek various investment objectives, such as generating income, hedging to mitigate risk, or speculation.
A long call option is an investment strategy where you buy the right to purchase a stock at a set price (the strike price) before expiration. The risk is limited to the amount you paid for the option, while the potential profit is unlimited if the stock price rises significantly.
To break even, the stock must finish above the strike price plus the cost of the option. For instance, if you buy a call with a $100 strike price for $5, the most you can lose is $500 (the option cost). If the stock rises above $105 at expiration, you begin to see profits—and the higher it goes, the greater the upside.
Source: Swan Global Investments
A long put option is a strategy where you buy the right to sell a stock at a predetermined price (the strike price) by expiration. The maximum risk is limited to what you paid for the option, while the potential profit grows as the stock price declines, with the most you could gain occurring if the stock falls all the way to zero.
To break even, the stock must finish below the strike price minus the cost of the option. For example, if you purchase a put with a $100 strike price for $5, the most you can lose is $500 (the option cost). If the stock drops below $95 at expiration, the trade moves into profit, and the lower the stock falls, the greater the potential reward.
Source: Swan Global Investments
Our portfolio managers and analysts are dedicated to creating relevant, educational Articles, Podcasts, White Papers, Videos, and more.
Options can provide downside risk mitigation. Buying a put option can hedge downside risk. For example, hedged equity is an investment approach that pairs equity investing with put options to define risk—offering a layer of downside risk mitigation while maintaining equity exposure. In another example, collar strategies allow investors to limit both downside and upside in exchange for stability.
Selling covered calls can provide additional return (from the collection of the option premium) on existing stock holdings. Options may serve as an equity income alternative, also known as derivative income, that can complement sources of portfolio income.
Options give investors the ability to adjust risk exposures, manage volatility, and fine-tune portfolios across market conditions. Options strategies can provide investors with noncorrelated sources of returns, providing additional diversification.
While options bring flexibility, they also carry important risks to consider:
Covered calls or collars can limit your upside potential—if the market rallies strongly, you’ll forgo gains past the strike price.
Buying puts isn’t free. During strong bull markets, the costs associated with protection can reduce overall returns.
Deploying multi-leg options strategies (like collars or overlays) requires careful design and monitoring of option liquidity and risk controls. Evaluating the many factors that go into option pricing, or validating the expertise and operational wherewithal of a manager, is difficult for amateur investors to assess.
Leverage is inherent in options. Call or put options are usually applied to 100 shares of the underlying asset per contract. Therefore, less capital (investment) is needed to gain asset exposure than purchasing the stock outright. Some options strategies utilize excessive leverage to improve returns, but it can also exacerbate losses. In addition, some options are thinly traded, and volatility can distort pricing, making execution costly or difficult.
Read more about the risks in options strategies here.
For decades, investors have relied on traditional securities for growth and income, while relying on diversification as their primary form of risk mitigation. However, since the Great Financial Crisis of 2007-09 (“GFC”), significant declines in interest rates and the convergence of asset correlations have redefined the investing landscape.
Let’s dive into each of these reasons a little further:
First, the interest rate environment affects where investors seek income.
The long-term secular bull market in the 10-year U.S treasury yields has ended and it appears the cycle has shifted towards higher rates in a world awash in debt.
Source: Source: Swan Global Investments, LLC, St. Louis Federal Reserve, Organization for Economic Co-operation and Development (OECD), Shiller, www.econ.yale.edu/~shiller/data.htm: 10-year U.S. Treasuries 1926-2021. The 60/40 portfolio refers to 60% Ibbotson US Large Stock Inflation Adjusted Total Return and 40% Ibbotson US IT Government Inflation Adjusted Total Return USD.
This creates a bit of a trap for investors seeking income. While higher interest rates seem intriguing for income investors, a prolonged, upward trend in rates threatens capital losses.
So investors seeking yield may continue to look to income alternatives, like dividend-paying stocks, REITs, MLPs, and options-based strategies, referred to as derivative income strategies. Derivative income strategies may pose lower duration risk than other alternatives, meaning less sensitivity to changes in interest rates.
Second, risk management has become more complicated after the Great Financial Crisis as well.
The convergence of asset classes has left investors looking for other ways to mitigate portfolio risk. The matrix below shows the correlations, or how assets move in relation to one another, of different assets since the Global Financial Crisis of 2007-09. In this matrix, a value of 1.0 means the two associated assets (row and column) move in the same proportion and in the same direction. Red and green hues are used to show high and low correlations, respectively.
The correlations between asset classes are much higher than they were previously. See our post on the correlation conundrum for a deeper discussion.
Asset Correlation Matrix
Source: Zephyr StyleADVISOR, Swan Global Investments
Faced with this new reality, investors are seeking new options.
Options and options-based strategies offer investors myriad ways to seek growth of capital, income, and risk mitigation. As such, options and options-based products have seen an explosion in popularity.
| Strategy | Objective | Pros | Cons / Risks | Best For |
| Covered Call | Generate income | Steady yield, easy to use | Caps upside, assignment risk | Income-focused investors |
| Protective Put | Hedge downside | Defined risk floor | Premium cost | Risk-sensitive investors |
| Collar Strategy | Limit downside, at the cost of some upside | Balanced protection | Requires multiple legs | Retirees, conservative investors |
| Cash-Secured Put | Buy a stock at a discount | Earn premium, buy lower | The stock may not drop to the strike | Value-focused buyers |
Options strategies can complement equities by reducing drawdowns, serve as alternatives to bonds in income-focused portfolios, and provide diversification benefits by smoothing returns in volatile markets.
Hedged equity strategies or funds can serve different roles in a portfolio, based on investor objectives, such as:
Derivative income or options-based income strategies or funds can be utilized:
Option overlay strategies can provide bespoke hedging and income solutions for investors with concentrated holdings or nuanced risk within a portfolio.
Why Swan Uses Options
At Swan, we view options as fundamental investment tools. As an innovative asset manager specializing in options strategies, we’ve been helping investors navigate uncertainty to achieve their long-term goals since 1997.
Our founder, Randy Swan, identified problems with assuming that historical correlations will remain consistent, especially during market crises. Thus, he pursued the use of options to directly mitigate risk and seek income generation.
Are options suitable for beginners?
Yes, but it’s typically recommended to start with buying calls, selling of covered calls, or buying protective puts, and to avoid complex strategies like spreads or multi-leg trades.
How risky are options compared to stocks?
Options can be safer (when hedging) or riskier (when leveraged). It depends on the strategy.
Can I use options in retirement accounts?
Some IRAs allow covered calls and protective puts, but strategies that require margin accounts or the selling of puts are usually not permitted.
Do options always expire worthless?
No. Options expire worthless if out-of-the-money, but in-the-money options have value.
What are the ‘Greeks’ in options?
Delta, gamma, theta, and vega measure sensitivity to price, time, and volatility changes.
Final Thoughts
Options offer investors practical ways to generate portfolio income, define and hedge risk, and seek growth of capital.
Strategies such as covered calls and protective puts are widely used by conservative investors, while more advanced strategies require greater expertise. Risks include premiums, complexity, and capped gains, so careful planning is essential.
At Swan Global Investments, we’ve been innovating and refining option-based strategies since 1997. We welcome the growth in popularity and use of options and options-based strategies. Whether through ETFs, mutual funds, or tailored SMAs and custom overlays, our goal is to help investors grow and preserve wealth.
Options: An option is a contract that gives the buyer the right to either buy (in the case of a call option) or sell (in the case of a put option) an underlying asset at a predetermined price by a specific date. Options are a powerful tool for creating a wide array of potential payoff profiles and may be used on a standalone basis or integrated into a broader portfolio strategy.
Expiry: The time until an option expires. In the context here, expiry is used to describe the length of time from when an option position is initiated to when it will expire.
Call option: A financial contract that gives the buyer the right to buy an underlying asset at a specific price within a specific period.
Covered call: A strategy of selling call options on an investor’s long position in a stock or futures contract. It can generate income in the form of option premium, lower risk, and improve returns by selling the right to buy stock shares or the call options contracts at a predetermined price.
Option premium: The price paid by the buyer of an options contract to the seller, reflecting the current market value.
At the Money: Refers to an options contract where an option’s strike price, or the price at which the option contract can be exercised, is identical to the price of the underlying security.
Near the Money: Refers to an options contract where an option’s strike price is close to the current market price of the corresponding underlying security.
Out of the Money: Refers to an options contract where an option’s strike price, or the price at which the option contract can be exercised, is much lower or higher than the price of the underlying security, and therefore the option contract only contains extrinsic value.
Intrinsic Value: Option value if exercised immediately.
Extrinsic value: Measurement of the difference between the market price of an option, called the premium, and its intrinsic value. Extrinsic value is also the time and volatility premium beyond the intrinsic value.
Strike Price: Price at which an option contract can be exercised, either to buy or sell the underlying security.
Option premium: The total amount that an investor will pay for an option.
Sharpe Ratio: Ratio used for calculating risk-adjusted return by measuring the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Standard Deviation: A measure of the dispersion of a set of data from its mean. The farther apart from the benchmark, the higher the deviation.
Beta: A measure of the volatility or dispersion of a security or a portfolio in comparison to the market as a whole.
Volatility: A statistical measurement of the degree of variability of the return of a security or market index.
Implied Volatility: A measure of investors’ collective forward-looking expectations of uncertainty or risk associated with the future movements of an asset; i.e. how much movement up or down the market is pricing in over a defined period.
Realized Volatility: A measurement of the actual movement of an asset’s price over a specified period in the past.
Max drawdown: Measures the most significant percentage decline in the value of an investment or portfolio from its peak to its lowest point before a new peak is achieved.
Delta: The theoretical estimate of how much an option’s value may change given a move up or down in the price of the underlying security.
Gamma: A measurement of how much an option’s Delta changes in response to movements in the underlying asset’s price. For example, a higher Gamma means the option’s Delta can shift quickly, even with small changes in the stock or fund’s price.
Theta: An options risk factor that measures the speed of decline in the value of an option as it approaches its expiration date; i.e. a measure of the impact of time decay.
Vega: The amount an option’s price is expected to change for a specific unit change in implied volatility.
Swan Global Investments, LLC is a SEC registered Investment Advisor that specializes in managing money using the proprietary Defined Risk Strategy (“DRS”). SEC registration does not denote any special training or qualification conferred by the SEC. Swan offers and manages the DRS for investors including individuals, institutions and other investment advisor firms.
All Swan products utilize the Defined Risk Strategy (“DRS”), but may vary by asset class, regulatory offering type, etc. Accordingly, all Swan DRS product offerings will have different performance results due to offering differences and comparing results among the Swan products and composites may be of limited use. All data used herein; including the statistical information, verification and performance reports are available upon request. The adviser’s dependence on its DRS process and judgments about the attractiveness, value and potential appreciation of particular ETFs and options in which the adviser invests or writes may prove to be incorrect and may not produce the desired results. There is no guarantee any investment or the DRS will meet its objectives. All investments involve the risk of potential investment losses as well as the potential for investment gains. Prior performance is not a guarantee of future results and there can be no assurance, and investors should not assume, that future performance will be comparable to past performance. Further information is available upon request by contacting the company directly at 970-382-8901 or www.swanglobalinvestments.com. 094-SGI-052825
