Your Mother Was Wrong About Stock Options

If you ask your mother about stock options, she will tell you that they are too risky for you to play with. As wonderful as she may be, in this particular case, mother does not know best.

Exchange traded options came into being for the purpose of reducing investors' risk in owning or acquiring stock. Even mother owns shares of some venerable old companies. What mom may not realize is that even her portfolio of blue chip stocks is subject to market losses.

STOCK OWNERSHIP INVOLVES RISK

A stock investor is always at risk of losing significant amounts of capital. Diversification can help offset some of the risk, but even diversified mutual fund holdings are not immune from market declines, such as those seen 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.

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. A "put" option gives the option buyer the right to sell 100 shares of stock at a specified 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.

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 to 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 virtually 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 that gives you the right to buy the stock at $30 per share.

Buying the call option for $2 per share allows you to control 100 shares of stock until the option expires. Assume that the stock behaves as expected and it appreciates to $40 per share. 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.

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, representing a minimum profit of $8 or a return of 400%!

Stocks do not always behave as we expect, however. 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. When we bought the call option, we limited our risk of loss to our purchase price so our maximum loss is $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 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 is that I will never have 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.

PROFITING WITH PUT OPTIONS

Put options can also be used to profit from anticipated market declines. You can buy a put option in expectation of a stock falling in 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.

MORE LIMITED RISK OPPORTUNITIES

This article is by no means a comprehensive exploration of options. We have highlighted a few low risk, simple strategies to highlight how options might be used in your portfolio to protect your current stock holdings and engage in limited risk trading scenarios.

Options provide an opportunity to protect positions against loss and also enhance returns. Anyone investing in the market today, or who is considering such investments, would do well to educate themselves about the benefits offered by options.