The words “derivative” and “stock option” have become synonymous with “high risk” in
public mind. This is an unfounded belief. Worse still, it is an unfortunate situation because truth is that stock options can significantly reduce risk within your investment portfolio. In fact, exchange traded options came into being for 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 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 risk, 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 most promising stock purchases, but cannot eliminate 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 buyer of option 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 seller of a call option has obligation of delivering shares of stock and seller of a put option has obligation of purchasing shares of stock. Because you are incurring an obligation when you sell an option contract, you potentially incur substantial risk. However, 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 stock. Options can also be used to protect stock holdings from loss, speculate in market, generate recurring income, and to enhance 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 stock for $3,000.00. Your maximum risk on trade is $3,000 and your upside potential is unlimited.
Alternatively, you could purchase a call option for a fraction of what underlying stock might cost. As owner of a call option you would have right to buy 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 call option for $2 per share allows you to control 100 shares of stock until option expires.
Let us assume that stock behaves as we expect and it appreciates to $40 per share in price. If you had bought stock, you could now sell it and realize a $10 per share profit. This represents a gain of 33% on capital invested, which is a very good return.
However, our call option has also appreciated in value because we have right to buy stock at $30 per share even though it is now trading at $40 per share. We paid $2 for 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 stock dropped in price and now trades at $25.00 per share. If we bought stock, we would have seen our position drop in value by $5 per share. By buying a call option, our risk is limited to $2 per share that we paid for 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.
