Options and other derivative products (things that derive their price from another financial instrument are called derivatives) are not inherently risky. They can be used to increase risk in a form of leverage or to decrease risk in a form of hedging. Derivatives allow you to take financial instruments the way they are packaged by the market and adjust their risk parameters to better meet your needs. Roger Clarke and Richard Bookstaber wrote extensively on this topic with respect to adjusting the risk in equity portfolios.
Let me give two examples of what I mean. First, let's examine using options to leverage your investment. Say you own Google. You feel it still has legs and will go up significantly. You decide to buy some at the money calls to mature next month. The GOPCP Mar 380 sold today for $23.70. You decide to buy 10 contracts for a total of $23,700.00.
You are betting that GOOG will go up more than $23.70 per share between now and the third Friday in March. GOOG closed today at $381.555. You have leveraged your holding of the stock. If the stock stays the same or goes down, you have lost $23,700 plus whatever you lost on the stock. If it goes up less than $23.70 per share, you still lose $23.70 minus however much it goes up minus however much you make on the stock. You win if it goes up more than $23.70 per share. You only win on one out of three scenarios - up a lot versus stay the same or go down.
The second example is for hedging the same stock. You think GOOG has gone up ALOT and you are nervous it is near its top. You want to protect your gains. You hedge your exposure by buying GOPOP Mar 380 at the money puts for $20.00. 10 contracts cover 1,000 shares, your investment in GOOG (worth $381,555.00 at today's close). It costs you $20,000 to protect your investment. If GOOG goes down you will always be able to sell the stock for $380 per share. If it goes down more than $20 per share you have a gain on the strategy. If it goes up or stays the same you lose money. But, you have reduced your risk of holding the stock.
Where many people get into trouble is in writing options or buying naked options with no underlying stock to set off gains or losses. I'll write about this another day.
» Options Risk - How to Tell For Yourself from MidMarketMaven
Larry Stay at GrowYourFunds kindly answered a question for me. I have a sense of my risk tolerance--and it doesn't include much option trading--but I know people who are option traders. I'd asked Larry to consider writing about gauging your... [Read More]
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