The words “derivative” and “stock option” have become synonymous with “high risk” in the public mind. This is an unfounded belief. Worse still,
It is an unfortunate situation because the truth is that stock options can significantly reduce risk within your investment portfolio. In fact, exchange-traded options came into being for the purpose of reducing investors’ risk in owning or acquiring stock.
STOCK OWNERSHIP INVOLVES RISK
Many people own stock in one form or another. If you have made stock purchases in the past, you are aware that you are risking a significant amount of capital. Companies like Enron and Worldcom were once considered “high flyers,” solid reputable companies, and good investments.
If you were invested in such stocks after early 2000, you likely lost much, if not all, of your investment.
A stock investor is always at risk of losing significant amounts of capital. Diversification can help offset some of the risks, but even diversified mutual fund holdings were not immune from market declines in 2000-2002.
A traditional stock investor can only protect their holdings by divesting themselves of their investments. In other words, a stock investor must sell some or all of her stock portfolio to reduce market risk.
Stop-loss orders are sometimes used to exit positions that decline in value, but such orders cannot guarantee an exit point. Fundamental and technical analysis is often used to seek out the most promising stock purchases, but cannot eliminate the potential for losses.
The stock market is a risky game if you do not know how to protect yourself against potential losses.
OPTIONS USED TO REDUCE MARKET RISK
Stock options are either “call” options or “put” options. A “call” option is a standardized contractual agreement that gives the buyer of the option the right to buy 100 shares of stock at a specified “strike” price on or before a specified “expiration” date.
Options may also be sold short, in which case the seller of a call option has the obligation of delivering the shares of stock and the seller of a put option has the obligation of purchasing shares of stock.
Because you are incurring an obligation when you sell an option contract, you potentially incur substantial risk. However, the risks associated with these sales can be limited to acceptable levels.
An investor or trader in securities can use options to control stock, without actually taking ownership of the stock. Options can also be used to protect stock holdings from loss, speculate in the market, generate recurring income, and enhance the overall return of stock holdings. All of these things are possible without exposing yourself to undue risk.
USING CALL OPTIONS INSTEAD OF BUYING STOCK
If you believe that a company’s stock is poised to appreciate and it is currently trading at $30.00 per share, you can purchase 100 shares of the stock for $3,000.00. Your maximum risk on the trade is $3,000 and your upside potential is unlimited.
Alternatively, you could purchase a call option for a fraction of what the underlying stock might cost. As the owner of a call option, you would have the right to buy the underlying stock at a pre-defined “strike” price.
Instead of paying $30 per share, you might only pay $2.00, perhaps less, for a call option with an “at-the-money” strike, i.e., $30 per share. Buying the call option for $2 per share allows you to control 100 shares of stock until the option expires.
Let us assume that the stock behaves as we expect and it appreciates to $40 per share in price. If you had bought the stock, you could now sell it and realize a $10 per share profit. This represents a gain of 33% on the capital invested, which is a very good return.
However, our call option has also appreciated in value because we have the right to buy the stock at $30 per share even though it is now trading at $40 per share. We paid $2 for the call and it is now worth at least $10, which represents a minimum profit of $8 or a return of 400%! All of a sudden, our 33% return is not so exciting because by using an option we risked only $2 but earned $8.
Stocks do not always behave as we expect. Let us assume that instead of rising in value the stock dropped in price and now trades at $25.00 per share. If we bought the stock, we would have seen our position drop in value by $5 per share.
By buying a call option, our risk is limited to the $2 per share that we paid for the position. When we buy a call option, we cannot lose more than what we paid for it. Our risk in this trade is limited to a maximum loss of $2 per share.
Call options are ideally suited for use when you expect a stock to make a significant move in the market. The use of a call option allows you to commit a relatively small amount of capital to control a stock for a set period of time. If you are correct in your expectations of stock movement, you can capture the positive price movement without exposing your capital to the additional market risk involved in a stock purchase.
USING PUT OPTIONS TO PROTECT YOUR STOCK HOLDINGS
I own a house. Every year I purchase an insurance policy to protect against unexpected damage or total loss of the house. My expectation and hope are that I will never have the need for the benefits afforded under the policy, but I pay the premiums nonetheless.
Just as you would insure your house by buying an insurance policy, you can buy a put option to insure your stock positions against unexpected loss. When you buy a put option, you have the right to sell your stock at a defined price for a defined period of time.
If your stock holdings fall in value, a put option will permit you to sell those depressed holdings at the pre-defined strike price.
Consider the example of a stock purchase we used above. Let us assume that you bought the call option and you decided to take ownership of the stock because you believed that it would continue to appreciate.
You already have an $8 profit, and you want to protect it against loss so you buy a $40 strike price put option for a cost of $1.50 per share. If the stock continues to rise in value, you will have no need for your put option and it will simply expire worthless, just as your homeowner’s insurance expires at the end of the policy term.
If something unexpected occurs in the market, causing your stock to drop in value, your position is protected against loss because you will be able to sell your stock at the pre-defined strike price of $40 per share.
PROFITING WITH PUT OPTIONS
When a trader expects a stock to decline in value, she might sell the stock short. Selling stock short requires a significant amount of capital and exposes you to significant risk if the market rallies to new highs.
Put options can also be used to profit from anticipated market declines. You can buy a put option in expectation of the market losing value. By buying a put option, you are only required to pay the cost of the option. There is no margin requirement. Your risk is limited to the amount you paid for the put.
Assume your stock dropped from $40 to $30, and you had paid $1.50 per share for a put option with a $40 strike price. Your maximum risk on the trade would be the $1.50 you paid for the put option. That put option would now be worth at least $10 since you have the right to sell a $30 stock for $40 per share. Your profit would be a minimum of $8.50, which represents a 560% profit.
Conversely, assume the stock gapped up at the market open to $45 per share. Your risk on the put option is limited to the $1.50 per share that you paid, while the short-stock trader has incurred a $5.00 per share loss.
PROFITING NO MATTER WHICH WAY A STOCK MOVES
Perhaps you do not know whether a stock will move up or down, but you do believe it is likely to make a significant move in one direction or another. A stock trader is at a loss because she does not know whether to buy stock or sell it short.
As an options trader, it is possible to profit by using an options strategy such as a straddle.
A straddle involves the simultaneous purchase of both a call and a put option. Assume your stock is trading at $30 per share and you expect that it will make a large move, but you are not sure whether it will be an upward or downward move.
You decide to buy a call and a put for a combined price of $3.50 per share. If the stock makes a large move to the upside, your call will gain value and your put will lose value. If the stock moves to the downside, your put will gain value but your call will lose value.
Because maximum loss is limited on both the call and the put, there is a finite value by which either can decline while providing unlimited profitability on the other side.
If the stock makes a large upside move to $45, your call will be worth a minimum of $15 per share. You paid $3.50 for the combined put and call, so your minimum profit would be $11.50, or a return of approximately 329%.
In the event of a large downside move to $20 per share, the put would have a minimum value of $10which would produce a minimum profit of $6.50 per share or a return of 186%. These returns are possible while risking no more on the trade than that combined amount paid for the call and put option.
MORE LIMITED RISK OPPORTUNITIES
This article is by no means intended to be a comprehensive exploration of options or option strategies. What this article attempts to demonstrate is that options can be used without significant financial risk. In fact, options are effective tools for limiting your risk in the market and, if properly used, are much less risky than stock investing.
For the stock investor, options provide an opportunity to protect positions against loss and enhance returns. Speculators can participate in the market without exposing themselves to large risks. Anyone actively investing in the market or who is considering such investments would do well to educate themselves about the benefits offered by options.
ABOUT THE AUTHOR: Christopher L. Smith, B.B.A., J.D., is a graduate of the University Of San Diego School of Business and Santa Clara University School of Law. He is a practicing lawyer, an active trader, a newsletter publisher, and the founder of The OptionClub.com