Your Mother Was Wrong About Stock Options

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

Exchange traded options came into being for the purpose ofreducing investors' risk in owning or acquiring stock. Evenmother owns shares of some venerable old companies. Whatmom may not realize is that even her portfolio of blue chipstocks is subject to market losses.

STOCK OWNERSHIP INVOLVES RISK

A stock investor is always at risk of losing significantamounts of capital. Diversification can help offset some ofthe risk, but even diversified mutual fund holdings are notimmune from market declines, such as those seen in2000-2002.

A traditional stock investor can only protect theirholdings by divesting themselves of their investments. Inother words, a stock investor must sell some or all of herstock portfolio to reduce market risk. Stop loss orders aresometimes used to exit positions that decline in value, butsuch 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 thatgives the buyer of the option the right to buy 100 sharesof stock at a specified "strike" price on or before aspecified "expiration" date. A "put" option gives theoption buyer the right to sell 100 shares of stock at aspecified price on or before a specified "expiration" date.

Options may also be sold short, in which case the seller ofa call option has the obligation of delivering the sharesof stock and the seller of a put option has the obligationof purchasing shares of stock. Because you are incurring anobligation when you sell an option contract, youpotentially incur substantial risk.

An investor or trader in securities can use options tocontrol stock, without actually taking ownership of thestock. Options can also be used to protect stock holdingsfrom loss, speculate in the market, generate recurringincome, and to enhance the overall return of stockholdings. All of these things are possible without exposingyourself to undue risk.

USING CALL OPTIONS INSTEAD OF BUYING STOCK

If you believe that a company's stock is poised toappreciate 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 upsidepotential is virtually unlimited.

Alternatively, you could purchase a call option for afraction of what the underlying stock might cost. As theowner of a call option you would have the right to buy theunderlying stock at a pre-defined "strike" price. Insteadof paying $30 per share, you might only pay $2.00, perhapsless, for a call option that gives you the right to buy thestock at $30 per share.

Buying the call option for $2 per share allows you tocontrol 100 shares of stock until the option expires.Assume that the stock behaves as expected and itappreciates 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 wehave the right to buy the stock at $30 per share eventhough it is now trading at $40 per share. We paid $2 forthe call and it is now worth at least $10, representing aminimum profit of $8 or a return of 400%!

Stocks do not always behave as we expect, however. Let usassume that instead of rising in value the stock dropped inprice and now trades at $25.00 per share. If we bought thestock, we would have seen our position drop in value by $5per share. When we bought the call option, we limited ourrisk of loss to our purchase price so our maximum loss is$2 per share.

Call options are ideally suited for use when you expect astock to make a significant move in the market. The use ofa call option allows you to commit a relatively smallamount of capital to control stock for a set period oftime. If you are correct in your expectations of stockmovement, you can capture the positive price movementwithout exposing your capital to the additional market riskinvolved in a stock purchase.

USING PUT OPTIONS TO PROTECT YOUR STOCK HOLDINGS

I own a house. Every year I purchase an insurance policy toprotect against unexpected damage or total loss of thehouse. My expectation and hope is that I will never haveneed for the benefits afforded under the policy, but I paythe premiums nonetheless.

Just as you would insure your house by buying an insurancepolicy, you can buy a put option to insure your stockpositions against unexpected loss. When you buy a putoption, you have the right to sell your stock at a definedprice for a defined period of time. If your stock holdingsfall in value, a put option will permit you to sell thosedepressed holdings at the pre-defined strike price.

PROFITING WITH PUT OPTIONS

Put options can also be used to profit from anticipatedmarket declines. You can buy a put option in expectation ofa stock falling in value. By buying a put option, you areonly required to pay the cost of the option. There is nomargin requirement. Your risk is limited to the amount youpaid 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 paidfor the put option. That put option would now be worth atleast $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 opento $45 per share. Your risk on the put option is limited tothe $1.50 per share that you paid, while the short-stocktrader has incurred a $5.00 per share loss.

MORE LIMITED RISK OPPORTUNITIES

This article is by no means a comprehensive exploration ofoptions. We have highlighted a few low risk, simplestrategies to highlight how options might be used in yourportfolio to protect your current stock holdings and engagein limited risk trading scenarios.

Options provide an opportunity to protect positions againstloss and also enhance returns. Anyone investing in themarket today, or who is considering such investments, woulddo well to educate themselves about the benefits offered byoptions.