Explain Option Trading In Terms Of A Risk Continuum

Don’t let the word ‘continuum’ make you click away; my point is that most investing neophytes think of stock options as risky investments and it’s just not the whole story. While it’s true that going long with calls or puts means that you are risking most or all of your investment funds in that particular position, it might be helpful to explain option trading in terms of a risk continuum, because the fact is that there are conservative option strategies as well as risky ones that traders can employ.

The idea of using just a little bit of money to control 100 shares of stock per contract that one buys, thereby benefiting from potential moves in the stock that one anticipates, is attractive for some traders or investors (and lots of speculators!). Certainly leverage has a place in some portfolios, to be taken on with only a small percentage of one’s investment capital. The stories one hears of traders doubling or tripling their money in a week or less certainly are accurate, though as you might expect the likelihood of this happening is quite low for most people, certainly much less than 50%. Having said that, one can still use a strategy of buying puts and calls when one has a hunch that a move might occur in the short-term. While long-term options, called LEAPS, can be employed successfully if you have a longer time horizon, buying options is usually done with an eye toward a short-term gain because of the time decay that premiums suffer as a contract gets closer to its expiration date.

So let’s look at the other side of this continuum. Many people with larger portfolios use writing, or selling, puts and calls as a way of augmenting their portfolio such that they actually reduce their overall risk exposure. If you think of options only as risky investment vehicles then that might surprise you-here’s how these conservative option trading strategies work:

Calls give us the right to buy or to sell 100 shares of the underlying stock by a given date in the future, but have you ever wondered who takes the other side of the transaction? In other words, from whom would you buy and to whom would you sell if you decided to exercise your call or put (respectively) at the contract expiration? Let’s talk about calls in this example.

If I own 100 shares of XYZ Company I might choose to sell you the right to buy those 100 shares at a given price (the strike price) on a given date (the expiration date). Why would I do that? With XYZ at 100 I might be happy to sell you the right to buy my XYZ shares at 120 for a nice gain for me, and for the the so-called options premium amount. Let’s say that the option that I sell you has four months of life left in it, and I think that it’s rather unlikely that XYZ will go up to 120 in the next four months. If it does go up to 120 though, I’ve decided I’d be happy to sell at that price.

Now 20 points, or 20% in this case, is quite a bit for a stock to move in four months, and it’s probably fairly unlikely that the move will occur in this period. Remember that if the move does not occur I get to keep my shares and the premium you paid me for a right to buy that you never exercised (you wouldn’t choose to exercise your 120 call when the price was under 120 at expiration, after all).

If IBM does rocket upward, higher than 120 before expiration, you, as the call buyer, have a happy decision to make. You can sell the call for hopefully more than you paid for it (the intrinsic value in this case will be $100 for each point over 120). Or, you can exercise your right to buy the 100 shares of IBM at 120, which will require $12,000, but would put you in quite a good position if the stock was at say 130 at expiration.

By the way, here we have an opportunity to talk about an extremely important aspect of options pricing: if IBM has recently been moving around quite a bit (either up, down or both), then in our example the market will price in a greater possibility that the stock will in fact move to 120 by expiration by inflating the value of the options contract compared to where the market would price it if IBM had moved in a range of just a point or two for the last six months. Regardless of the historical volatility of the stock, no one knows just how volatile its price will be going forward of course, and in turn just how likely the stock is to reach the strike price. The market will price the option according to the data that has i.e. what has already occurred.

For this reason you should understand that in our example one call contract might have been priced at less than $10 or it might have been priced at several hundred dollars. As the the call was out of the money, i.e. the stock price was below the strike price, its entire value was so-called time value, which can be thought of as a quantification by the market of the the likelihood of the stock price exceeding the strike price by expiration. Depending on the various strike prices and expiration dates of options on a particular stock, we can decide just how risky and leveraged we’d like to be in a given position, whether we are on the buy side or the sell side. Hopefully the word ‘continuum’ seems appropriate to you now, when we refer to various risk/reward scenarios into which we can enter with stock options.

It should be clear that you cannot explain option trading simply as speculation or outright gambling. While options are appropriate as leveraged trading vehicles, they are also used creatively by many investors to reduce overall portfolio risk, by taking the opposite side of trades made by people who are willing to assume risk. Regardless of your situation, make very sure that you get stock options explained to you by a financially savvy friend or good quality financial site online, before you ever risk real money in a trade.