Option trade risk

Reducing Risk With Options.

Many people mistakenly believe that options are always riskier investments than stocks. This stems from the fact that most investors do not fully understand the concept of leverage. However, if used properly, options can have less risk than an equivalent position in a stock. Read on to learn how to calculate the potential risk of stock and options positions and discover how options - and the power of leverage - can work in your favor.

[ Looking for a shortcut to calculating risk when trading options? Investopedia Academy's Options for Beginners course provides you with an advanced Options Outcome Calculator that gives you the data you need to decide on the right time to buy and sell puts and calls. ]

Leverage has two basic definitions applicable to option trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into trouble. A dollar amount invested in a stock and the same dollar amount invested in an option do not equate to the same risk.

The second definition characterizes leverage as maintaining the same sized position, but spending less money doing so. This is the definition of leverage that a consistently successful trader incorporates into his or her frame of reference.

Interpreting the Numbers.

Consider the following example. If you're going to invest $10,000 in a $50 stock, you might be tempted to think you would be better off investing that $10,000 in $10 options instead. After all, investing $10,000 in a $10 option would allow you to buy 10 contracts (one contract is worth one hundred shares of stock) and control 1,000 shares. Meanwhile, $10,000 in a $50 stock would only get you 200 shares.

In the example above, the option trade has much more risk compared to the stock trade. With the stock trade, your entire investment can be lost, but only with an improbable movement in the stock. In order to lose your entire investment, the $50 stock would have to trade down to $0.

In the option trade, however, you stand to lose your entire investment if the stock simply trades down to the long option's strike price. For example, if the option strike price is $40 (an in-the-money option), the stock will only need to trade below $40 by expiration for your entire investment to be lost. That represents only a 20% downward move.

Clearly, there is a large risk disparity between owning the same dollar amount of stocks to options. This risk disparity exists because the proper definition of leverage was applied incorrectly to the situation. To correct this problem, let's go over two alternative ways to balance risk disparity while keeping the positions equally profitable.

Conventional Risk Calculation.

The first method you can use to balance risk disparity is the standard, tried and true way. Let's go back to our stock trade to examine how this works:

If you were going to invest $10,000 in a $50 stock, you would receive 200 shares. Instead of purchasing the 200 shares, you could also buy two call option contracts. By purchasing the options, you can spend less money but still control the same number of shares. The number of options is determined by the number of shares that could have been bought with your investment capital.

For example, let's suppose that you decide to buy 1,000 shares of XYZ at $41.75 per share for a cost of $41,750. However, instead of purchasing the stock at $41.75, you could also buy 10 call option contracts whose strike price is $30 (in-the-money) for $1,630 per contract. The option purchase will provide a total capital outlay of $16,300 for the 10 calls. This represents a total savings of $25,450, or about a 60% of what you could have invested in XYZ stock.

This $25,450 savings can be used in several ways. First, it can be used to take advantage of other opportunities, providing you with greater diversification. Another interesting concept is that this extra savings can simply sit in your trading account and earn money market rates. The collection of the interest from the savings can create what is known as a synthetic dividend. Suppose during the course of the life of the option, the $25,450 savings will gain 3% interest annually in a money market account. That represents $763 in interest for the year, equivalent to about $63 a month or about $190 per quarter.

You are now, in a sense, collecting a dividend on a stock that does not pay one while still seeing a very similar performance from your option position in relation to the stock's movement. Best of all, this can all be accomplished using less than one-third of the funds you would have used had you purchased the stock.

Alternative Risk Calculation.

The other alternative for balancing cost and size disparity is based on risk.

As you've learned, buying $10,000 in stock is not the same as buying $10,000 in options in terms of overall risk. In fact, the money invested in the options was at a much greater risk due to the greatly increased potential of loss. In order to level the playing field, therefore, you must equalize the risk and determine how to have a risk-equivalent option position in relation to the stock position.

Let's start with your stock position: buying 1,000 shares of a $41.75 stock for a total investment of $41,750. Being the risk-conscious investor that you are, let's suppose you also enter a stop-loss order, a prudent strategy that is advised by most market experts.

You set your stop order at a price that will limit your loss to 20% of your investment, which is $8,350 of your total investment. Assuming this is the amount that you are willing to lose on the position, this should also be the amount you are willing to spend on an option position. In other words, you should only spend $8,350 buying options. That way, you only have the same dollar amount at risk in the option position as you were willing to lose in your stock position. This strategy equalizes the risk between the two potential investments.

If you own stock, stop orders will not protect you from gap openings. The difference with the option position is that once the stock opens below the strike that you own, you will have already lost all that you could lose of your investment, which is the total amount of money you spent purchasing the calls. However, if you own the stock, you can suffer much greater losses. In this case, if a large decline occurs, the option position becomes less risky than the stock position.

For example, if you purchase a pharmaceutical stock for $60 and it gap-opens down at $20 when the company's drug, which is in Phase III clinical trials, kills four test patients, your stop order will be executed at $20. This will lock in your loss at a hefty $40. Clearly, your stop order doesn't afford much protection in this case.

However, let's say that instead of purchasing the stock, you buy the call options for $11.50 each share. Now your risk scenario changes dramatically - when you buy an option, you are only risking the amount of money that you paid for the option. Therefore, if the stock opens at $20, all of your friends who bought the stock will be out $40, while you will only have lost $11.50. When used in this way, options become less risky than stocks.

Determining the appropriate amount of money you should invest in an option will allow you to use the power of leverage. The key is keeping a balance in the total risk of the option position over a corresponding stock position, and identifying which one holds the higher risk in each situation.

Option Trading Risks.

What Are Option Trading Risks?

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Option Trading Risks : The Official Word.

The option trading risks pertaining to options buyers are:

The option trading risks pertaining to options sellers are:

Other option trading risks mentioned are:

Option Trading Risks : The Offical Word In Short.

Option Trading Risks : 3 Macro Risk Factors.

Primary Risk (Market Risk)

Primary risk or Market risk is the risk that the overall market failed to move in your expected direction. If you are long calls on a whole portfolio of stocks then primary risk would be the risk that the market might crash, taking all your calls out of the money (OTM). In general, the more stocks and the more diversified the stocks that you invest in, the higher the chance that your portfolio will move as a whole closer to how the overall market is moving. Remember, the Dow that we know today is made up of 30 stocks. Buying shares or call options on these 30 stocks will give you a portfolio that moves exactly how the Dow is moving. This is a significant option trading risks if you are executing Long Call Options strategy across a wide portfolio of stocks.

Secondary Risk (Sector Risk)

Secondary risk or Sector risk is the risk that a whole sector of stocks failed to do well. There are times when specific market sectors do not do well due to fundamental economic reasons, causing all stocks in those particular sectors to crash. This is a significant option trading risks for option traders who executes bullish strategies on stocks from only a couple of sectors.

Idiosyncratic Risk (Individual Stock Risk)

Idiosyncratic risk is the risk that shares of a company you bought is effected by events that happens to that particular company. If you buy shares of XYZ company, you run the idiosyncratic risk of that company going bankrupt all of a sudden. This is an option trading risks that affects option traders who put all their money on the options of a single stock most.

Benefits & Risks of Options Trading.

You may be wondering - why would an investor want to get involved with complicated options, when they could just go out and buy or sell the underlying equity? There are a number of reasons such as:

An investor can profit on changes in an equity’s market price without ever having to actually put up the money to buy the equity. The premium to buy an option is a fraction of the cost of buying the equity outright. When an investor buys options instead of an equity, the investor stands to earn more per dollar invested - options have "leverage." Except in the case of selling uncovered calls or puts, risk is limited. In buying options, risk is limited to the premium paid for the option - no matter how much the actual stock price moves adversely in relation to the strike price.

Given these benefits, why wouldn’t everyone just want to invest with options? Options have characteristics that may make them less attractive for certain investors.

Options are very time sensitive investments. An options contract is for a short period - generally a few months. The buyer of an option could lose his or her entire investment even with a correct prediction about the direction and magnitude of a particular price change if the price change does not occur in the relevant time period (i. e., before the option expires). Some investors are more comfortable with a longer term investment generating ongoing income - a "buy and hold" investment strategy. Options are less tangible than some other investments. Stocks offer certificates, as do bank Certificates of Deposit, but an option is a "book-entry" only investment without a paper certificate of ownership.

Options aren’t right for every investor and are just right for others. Options can be risky but can also provide substantial opportunities to profit for those who properly use this very flexible and powerful financial instrument.

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Options Basics Tutorial.

Nowadays, many investors' portfolios include investments such as mutual funds, stocks and bonds. But the variety of securities you have at your disposal does not end there. Another type of security, known as options, presents a world of opportunity to sophisticated investors who understand both the practical uses and inherent risks associated with this asset class.

The power of options lies in their versatility, and their ability to interact with traditional assets such as individual stocks. They enable you to adapt or adjust your position according to many market situations that may arise. For example, options can be used as an effective hedge against a declining stock market to limit downside losses. Options can be put to use for speculative purposes or to be exceedingly conservative, as you want. Using options is therefore best described as part of a larger strategy of investing.

This functional versatility, however, does not come without its costs. Options are complex securities and can be extremely risky if used improperly. This is why, when trading options with a broker, you'll often come across a disclaimer like the following:

Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

Options belong to the larger group of securities known as derivatives. This word has come to be associated with excessive risk taking and having the ability crash economies. That perception, however, is broadly overblown. All “derivative” means is that its price is dependent on, or derived from the price of something else. Put this way, wine is a derivative of grapes; ketchup is a derivative of tomatoes. Options are derivatives of financial securities – their value depends on the price of some other asset. That is all derivative means, and there are many different types of securities that fall under the name derivatives, including futures, forwards, swaps (of which there are many types), and mortgage backed securities. In the 2008 crisis, it was mortgage backed securities and a particular type of swap that caused trouble. Options were largely blameless. (See also: 10 Options Strategies To Know .)

Properly knowing how options work, and how to use them appropriately can give you a real advantage in the market. If the speculative nature of options doesn't fit your style, no problem – you can use options without speculating. Even if you decide never to use options, however, it is important to understand how companies that you are investing in use them. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.

This tutorial will introduce you to the fundamentals of options. Keep in mind that most options traders have many years of experience, so don't expect to be an expert immediately after reading this tutorial. If you aren't familiar with how the stock market works, you might want to check out the Stock Basics tutorial first.