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Home > Investing > Think Options Are Risky? Here’s Why You Should Use Them!

Think Options Are Risky? Here’s Why You Should Use Them!

February 28th, 2012 Leave a comment Go to comments

If you think stock investing is risky, then option investing is even riskier. There is some truth to this but it very much depends on what it is you are trying to do. If you invest in low beta stocks or in Dividend Aristocrats, you can lower your investment risk. Similarly, there are option strategies that are very conservative.

The Risky Option Strategy

The risky way to use options is to buy an option in the expectation of a specific outcome. If that outcome doesn’t occur you lose your money because time runs out on the option. For example, let’s say you think that Ford (F) is going to have a great quarter.

It’s a high beta stock, which means that the implied volatility could cause a big move your way. You buy say a future 3 month option for 30 cents at a strike price of $13. Let’s say that Ford does great, blows out the quarter and then trades at $15 the next day.

What happens? Well, your 30 cent investment is now worth $2.00 ($15.00-$13.00) or 200/30, 6 times your investment! This is an attractive strategy to make money. But, if the stock never trades above $13 before the 3 month ends, you lose all your money invested.

This is riskier than buying the stock. If you bought the stock outright, you could at least wait a while longer to get $15/share. The option limits your ability to wait because it’s end dated.

The Low Risk Option Strategy

The lowest risk option strategies are where you are the seller of the option and not the buyer as above. For every option buyer, there is an option seller just like stocks. When you sell an option you collect a premium that you get to keep no matter what. Then, depending on what happens with the option you might need to do something or possibly nothing. If nothing happens, you keep the premium! In most cases, you will be happy either way as I describe below!

These conservative option strategies provide the following opportunities:

  1. Buying a stock at a lower price.
  2. Selling a stock at a much higher price.

The cardinal rule of stock investing is to buy low and sell high. That’s what these sell option strategies enable your to do. And even if they don’t, you still earn a positive return for your trouble.

A Visual View

Selling A Put

As shown in the visual, selling a put is useful when you want to buy a stock in the future at a lower price than it is trading today.

This terminology is at first difficult to grasp, so look at it from the point of view of the buyer. An investor will buy a put as insurance against a position. This means that the buyer will be able to sell the stock at set price (presumably higher than a future lower price), enabling the buyer to get at least the strike price during the duration of the option. This will protect the investor from a severe drop in price.

Where there is a buyer, there is a seller. You are selling the put, which will make you the buyer of the stock if it’s exercised. Confusing at first, but read this paragraph again, it will make sense.

Here’s how this works. If a severe drop in price occurs such that it is lower than the strike price you may be obligated to buy the stock. If you are willing to buy the stock today, or think the price is too high, then you should be more than willing to take it off the other investors hands at the lower price.

Don’t assume that the investor buying the put has any misgivings about owning the stock. Options are used for all kinds of reasons, including providing some insurance against unwarranted market drops.

Selling A Covered Call

Selling a covered call enable you to sell a stock in the future at a higher price than today’s price.

Let’s assume that you own a stock that you bought it ‘low’. Now it’s outside it’s fair value range, maybe even overvalued. Selling a covered call enables you to sell the stock for an even higher price while collecting a premium for the privilege! The buyer of this option could have many reasons to want to buy this option. He may want to establish a position in a stock in the future using a small amount of money. Buying this call enables the investor to do that, once you sell the call you no longer control the shares once the stock price reaches the strike price.

Be clear about your motivations when writing such an option. If you want to hold the stock regardless you may want to use this option on some other position that you really are ambivalent about selling. Remember, stock markets can be irrational on the upside as well as the downside, so that high price you think may not happen can happen.

What Are The Risks?

The major risks of these option strategies, apart from the typical risks associated with investing in stocks at all, are what economists call opportunity costs. Each strategy for any position will have an implied return range that you will know ahead of time, which could be a lot lower than other investment opportunities that could come up. For example, a conservative strategy would dictate that you actually have the cash available in a secure holding in case you are obligated to buy stock from your put option. This necessarily means that you can’t use that cash for anything else if another opportunity comes up.

In some cases, this isn’t a downside. It’s good idea to invest some of your money selling puts because it offers the ability to earn a higher return than cash in the short term with a potential for future upside if you buy the stock.

Also, the covered call does limit your upside potential. By selling the covered call, you may be giving the option buyer additional upside that you would have if you continued to own the stock.

Like any investment strategy, experience will tell you when it makes sense.

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  1. February 28th, 2012 at 09:13 | #1

    Nice overview of options. I’ve been trying to learn more about this strategy, but honestly it’s still out my realm of comfort at the moment. I’ve read a couple of books about options in an attempt to educate myself more about it. Any good reads you would recommend?

  2. February 28th, 2012 at 18:26 | #2

    Stoic, I recommend the book ‘The Rookie’s Guide to Options’ by Mark Wolfinger.

    I’m still learning, in the future I will try to publish any option trades I do. My goal is to obtain, say, a 9-10% overall return from cash, using preferreds then writing options against the position. It’s doable.

  3. February 29th, 2012 at 23:09 | #3

    SFI– Thanks for the suggestion…

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