Thoughts for beginners part 5: How risky are options?
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.