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Thoughts for beginners part 5: How risky are options?

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March 26, 2013 – Comments (11)

I am more of a macro investor than individual stocks...not the best with those.  I remember there were a bunch of questions that I had that confused me when I was brand new.  A handful of CAPS players got me to where I am today, so I am offering my opinion on a few misconceptions.  There will probably be about 10 of these blogs over the course of a few weeks.  

 

In this blog I want to discuss how options can be used to REDUCE risk, and how and why they can also INCREASE risk.

 

Many small investors forget that you can sell options, and not just buy them.  While I never recommend selling options without owning the underlying stock/etf, selling stocks as a covered call can REDUCE risk.  If you own a stock at $10, and you sell an $11 strike option for $1, you lower your cost basis to $9, even if you cap your upside.  If the market falls while vix spikes, when vix is high option premiums are high, and this is also during periods when it pays to be cautious.  So this is a good time to do covered calls.

How else can options reduce risk?  The reason many people see options as increasing risk is as follows:  Lets say you have $10,000 to invest.  Stock of company ABC is trading at $100 a share, and the options you are looking to buy trade for $1 (x 100 shares = $100 total purchase price).  At $100 a share you can afford to buy 100 shares.  Then your entire $10,000 is at risk.  If you choose to instead buy one call option, which gives you the right to buy 100 shares if the option goes in the money, you only have to pay $100 for this right, and your total capital at risk is only $100 instead of $10,000.  Obviously this makes your position much less risky.  When it becomes way more risky, is when you decide to buy $10,000 worth of options, which gives you the option to buy 10,000 shares of the underlying.  Your risk is increased because now time is working against you.  If you measure it in dollar terms ($10k of stock versus $10k of options), options increase risk.  If you measure it in share terms (100 shares versus 1 call), options reduce risk.

 

If you don't understand how options work, you can google a quick tutorial and then his blog will make a lot more sense.  Many people see options as inherently risky, but they are actually tools for decreasing risk, as long as you use them in certain ways. 

11 Comments – Post Your Own

#1) On March 26, 2013 at 6:05 PM, TheDumbMoney (37.72) wrote:

Nice concise post.  I'd note that the vast majority of individuals cannot afford to sell covered calls, because each option contract represents 100 shares.  So it's easy to sell a covered call on BAC.  But 99% of individuals will never be able to sell a covered call on GOOG.  This has changed somewhat with the investion of mini-options for some tickers, but it's still the primary reason why individuals typically are in the market to buy options, not to sell them, and why they typically elevate an individual investor's risk exposure, assuming one defines risk at least in part as the chance of permanent loss of capital.

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#2) On March 26, 2013 at 6:11 PM, Option1307 (29.65) wrote:

This is a pretty good series for beginners, nice work.

I definitely echo what was said in comment number #1, I bet that the majority of people/Fools don't have the ability to sell covered calls by the amount of shares is simply out of their comfort zone. But you're right, options can be used to reduce risk if used correctly.

+1 

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#3) On March 26, 2013 at 6:31 PM, Valyooo (99.35) wrote:

Well I personally think people should not invest unless they have at least $10,000 to invest.  This makes covered calls viable to any stock under $100 a share, which is most.  And the mini-options on google, amazon, and apple was a great idea...valid points absolutely though, but not totally out of reach.

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#4) On March 26, 2013 at 7:57 PM, HarryCarysGhost (99.69) wrote:

Hey Valy,

Great job on this blog series it's much appreciated.

However I strongly disagree with this statement-

Well I personally think people should not invest unless they have at least $10,000 to invest.

How are beginners, or young people supposed to even get started investing if you put a floor on start price?

Personally I started with a $900 tax refund, with todays low commission brokerages it's no longer mandatory to have large sums to invest.

This boils down to our differing philosophys where I believe in building massive wealth over time, where your more into instant gratification.

Different strokes for different folks.

Cheers.

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#5) On March 26, 2013 at 8:11 PM, Imperial1964 (97.77) wrote:

You might also consider (buying) options riskier because 70% of options expire worthless--as in you lose all of the purchase price--and only 10% return a profit.  The most likely outcome of buying options is a 100% loss (though that varies by strike price, volatility, duration, etc.).

Inversely, as you pointed out in different words, the risk with selling options is that in the event you have a loss, your loss (or loss of profit potential) will likely be very large compared to the small potential gain.

 

I dabble in options once in a while, but not often.

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#6) On March 26, 2013 at 10:17 PM, awallejr (85.54) wrote:

If the market falls while vix spikes, when vix is high option premiums are high

That is the best value of the Vix I have read.  

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#7) On March 26, 2013 at 10:20 PM, awallejr (85.54) wrote:

with todays low commission brokerages it's no longer mandatory to have large sums to invest.

That has changed things so dramatically Harry.  I remember when you paid a percentage as a commission which would could turn a winning investment into a losing one.

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#8) On March 27, 2013 at 2:57 PM, JaysRage (88.89) wrote:

I love these articles.   They are great for generating great conversation on all of these topics.   Thanks for doing this!  

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#9) On March 27, 2013 at 3:17 PM, Valyooo (99.35) wrote:

@jaysrage,

No problem, I wish I could do more.  This isn't only for beginners, even people who have been doing this for a while can probably get a different insight from these blogs.  It took me a while to learn all of these things.

 

HCG, you might be right.  I just like 10k because you can diversify slightly without commission eating away at you. But I don't think investing is the only thing to worry about when young.  I think people should focus more on saving then investing, when investing is going to earn them only an extra 20 bucks a year, unless they plan on doing it for a living.  You are right that I am more into instant gratification, but that is not what I was aiming for...nobody is going to retire on 10k.  I meant start with 10k then slowly add more and invest for decades....not take 10k and try to turn it into a million in 2 months, but that would be nice! ;)  

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#10) On March 27, 2013 at 7:29 PM, ChrisGraley (29.65) wrote:

Just My 2 cents, but I kind of agree with both sides of the 10k argument. 

Investing spans many more choices than stocks, bonds and options. There is nothing wrong with making a dollar and investing a dollar if you have met your obligations and have a safety net. A good example would be www.kiva.org. You can make money and help people at the same time and invest tiny amounts.

That being said, you need a safety net. I like to reccommend to friends that they keep 6 months income in fairly liquid assets. You never know when you will lose a job or have a health condition or some other life changing event. Being forced to sell your stocks or options when the market doesn't agree with you is a humbling experience.

This is a great article and the feedback is great as well. It reminds me of a time when this website had a little more life in it. 

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#11) On March 27, 2013 at 8:33 PM, awallejr (85.54) wrote:

I like to reccommend to friends that they keep 6 months income in fairly liquid assets.

Good advice and something I follow.

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