The highs and lows of stock market investing can be nerve wracking, even for the most experienced investors. Taking risks with your money is always a source of anxiety. Fortunately, there are some investment risk management strategies you can utilize when pursuing larger investments in the stock market.
One way you can gain access to the market without the risk of actually buying stocks or selling stocks is through options. Because options trade at a significantly lower price than the underlying share price, option investing is a cheaper way to control a larger position in a stock without truly taking ownership of its shares. The strategic use of options can allow you to mitigate risk while maintaining the potential for big profits, at only a fraction of the cost of buying shares of a stock.
What exactly is an option? An option is the right to buy or sell a security at a certain price within a specified time frame. Rather than owning the shares outright, you’re making a calculated bet on the future of a stock’s price within the time period specified by the option. The best thing about options is that you have the freedom to choose whether or not to exercise them. If you bet wrong, you can just let your options expire. Though you’d lose the original cost of the options, you also avoid the hefty losses you would have otherwise incurred had you paid full price for the stock.
With all this talk about how great options are, it seems like everyone should buy options, right? After all, they’re cheaper and have lower risk. Well, not so fast. Don’t forget about two things:
- the limited-time aspect of options
- the fact that you don’t actually have ownership of the stock until you’ve exercised your options
I’ll delve further into these risks in the context of the examples below for both call and put options.
Now, here is a detailed analysis of the two basic types of options: put options and call options.
How Call Options Work
When you choose a call option, you’re paying for the right to buy shares at a certain price within a specified time frame. Consider an example in which shares of Nike (NYSE: NKE) are selling for $90 in July. If you think that the price will increase over the next few months, you could buy a six-month option to purchase 100 shares of Nike by January 31 at $100. You would pay roughly $200 for this call option assuming it costs about $2 per share (remember that you can only buy in 100 share increments when it comes to options), which would in turn give you the option to acquire 100 shares of Nike anytime within the next six months. Compare that to the $9,000 you would have paid had you wanted to buy the shares outright ($90 multiplied by 100 shares) and the difference is significant.
Scenario 1: On December 10, if shares of Nike are trading at $115, you can exercise your call option and net a $1,300 gain (the $15 profit per share multiplied by 100 shares minus the $200 original investment). You could alternatively choose to make a profit by re-selling your option on the open market to another investor. This will often lead to a similar gain.
Scenario 2: If, however, Nike’s share prices fell and never reached $100 during the six-month period, you could just let the option expire and save your money. Your only loss would be the original $200 cost.
Now, let’s analyze the potential risk of investing in options. First, in Scenario 1 where Nike’s shares never reach $100 and you lose the entire $200 original investment, what was your percentage loss? 100%! As bad a day or year as anyone has had in the market selling stock, you’ll rarely find someone who has incurred a 100% loss. The only way this can happen is if the underlying company went bankrupt and their stock price went to zero.
As you can see, options can lead to huge losses, especially when you analyze it from a percentage point of view. To further illustrate this point, let’s say Nike’s share price was $99 on the last day you could exercise your options. Of course, you wouldn’t exercise them because you would lose a dollar on every share. But what if you had instead invested $9,000 for the actual stock and owned 100 shares. Well, on this day that marked six months out from the original investment, you would have a 10% gain ($99 versus $90). Imagine that: a 100% loss (options) vs. a 10% gain (stock). As you can see, the risks of options can’t be overstated.
To be fair, the opposite is true for the upside. If the stock was trading at higher than $100, you would have a substantially higher percentage gain with options than stock. For example, if the stock was trading at $110, that would imply a 400% gain ($10 gain compared to the original $2 investment per share) for the option investor and a roughly 22% gain for the stock investor ($20 gain compared to the original $90 investment per share).
Lastly, with owning stock, there is nothing ever forcing you to sell. For example, if after six months, the shares of Nike have gone down, you can simply hold onto the stock if you feel like it still has potential. A year later, if it’s gone up drastically, you’ll make a significant gain without ever having incurred any losses. However, had you chosen to invest in options, you simply would have been forced to incur a 100% loss after six months with no choice to hold onto it even if you feel like the stock will go up from there.
Thus, as you can see, there are major pros and cons of options, all of which you need to be keenly aware of before stepping into this exciting investing arena.
How Put Options Work
A put option is the exact opposite of a call option. This is the option to sell a security at a specified price within a specified time frame. Investors often buy put options as a form of protection in case a stock price drops suddenly or the market drops altogether. Put options give you the ability to sell your shares and protect your investment portfolio from sudden market swings. In this sense, put options can be used as a way for hedging your portfolio, or lowering your portfolio’s risk.
In this example, you own 100 shares of Clorox (NYSE: CLX) stock, which you purchased for $50 a share. As of January 31, the stock has gone up to $70 per share. You want to maintain your position in Clorox, but you also want to protect the profits you’ve made, just in case the stock price drops. To fit your needs, you can buy a six-month put option at a strike price of $70 per share.
Scenario 1: If Clorox stock takes a beating over the next few months and falls to $60 per share, you’re protected. You can exercise your put option and still sell your shares for $70 each even though the stock is trading at a significantly lower price. And if you feel confident that Clorox stock will recover, you could hold onto your stock and simply resell your put option, which will surely have gone up in price given the dive that Clorox stock has taken.
Scenario 2: If, on the other hand, shares of Clorox kept climbing, you’d let your option expire and still reap the benefit of the increased value of the shares you own. Yes, you’d lose out on what you invested into the options, but you still haven’t lost the underlying stock. Thus, one way to look at it in this example is that the options are an insurance policy which you may or may not end up using. As a quick side note, you can buy put options even without owning the underlying stock in the same manner as call options. There is no requirement of owning the stock.
The exact same risks apply as detailed in the Call Options section above. Buying the put options has the potential for a 100% loss if the stock goes up, but also the potential for huge gain if the stock goes down since you can then resell the options for a significantly higher price.
Options are a great way to open the door to bigger investment opportunities without risking large amounts of money up front. But remember that trading options is for sophisticated investors only. If you’re a new trader with an online account, don’t try this on your own unless you’ve talked with a professional and are comfortable with the basics.
This warning arises out of the fact that options trading comes with plenty of risk which have been detailed above. These transactions are about proper timing, and they require intense vigilance. Sophisticated investors have enough experience to be familiar with options strategies and have the comfort level necessary to use them. If you’re not careful and miss the right time to exercise an option, or your initial bet simply doesn’t work out, you can lose a ton of cash in the form of 100% of your initial investment. Also, options are just a part of an investing strategy and should not represent an entire portfolio.
Have you taken advantage of put or call options? Do you have any interesting success or failure stories? Tell us about your experience with options in the comments below.