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Risk Management And Options - Options Basics

The power of options lies in their versatility. They enable you to adapt or adjust your position according to any situation that arises. Options can be as speculative or as conservative as you want. This means you can do everything from protecting a position from a decline to outright betting on the movement of a market or index.

This versatility, however, does not come without its costs. Options are complex securities. This is why, when trading options, you'll see a disclaimer like the following:

Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Only invest with risk capital.

Option trading involves risk, especially if you don't know what you are doing. Because of this, many people suggest you steer clear of options and forget their existence. (For an opposing view, read 5 Reasons Young Investors Should Trade Options.)

On the other hand, being ignorant of any type of investment places you in a weak position. Without knowing about options you would not only forfeit having another item in your investing toolbox, you would also lose insight into the workings of some of the world's largest corporations. Whether it is to hedge the risk of foreign-exchange transactions or to give employees ownership in the form of stock options, most multi-nationals today use options in some form or another.

This section will introduce you to the fundamentals of options.

Options Basics: What Are Options?
An option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price on or before a certain date. An option, just like a stock or bond, is a security. It is also a binding contract with strictly defined terms and properties.

Still confused? The idea behind an option is present in many everyday situations. Say, for example, that you discover a house that you'd love to purchase. Unfortunately, you won't have the cash to buy it for another three months. You talk to the owner and negotiate a deal that gives you an option to buy the house in three months for a price of $200,000. The owner agrees, but for this option, you pay a price of $3,000.

Now, consider two theoretical situations that might arise:

1. It's discovered that the house is actually the true birthplace of Elvis! As a result, the market value of the house skyrockets to $1 million. Because the owner sold you the option, he is obligated to sell you the house for $200,000. In the end, you stand to make a profit of $797,000 ($1 million - $200,000 - $3,000).

2. While touring the house, you discover not only that the walls are chock-full of asbestos, but also that the ghost of Henry VII haunts the master bedroom; furthermore, a family of super-intelligent rats has built a fortress in the basement. Though you originally thought you had found the house of your dreams, you now consider it worthless. On the upside, because you bought an option, you are under no obligation to go through with the sale. Of course, you still lose the $3,000 price of the option.

This example demonstrates two very important points. First, when you buy an option, you have a right but not an obligation to do something. You can always let the expiration date go by, at which point the option becomes worthless. If this happens, you lose 100% of your investment, which is the money you used to pay for the option. Second, an option is merely a contract that deals with an underlying asset. For this reason, options are called derivatives, which means an option derives its value from something else. In our example, the house is the underlying asset. Most of the time, the underlying asset is a stock or an index.

Calls and Puts
The two types of options are calls and puts.

A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires.

A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Participants in the Options Market
There are four types of participants in options markets depending on the position they take:

1. Buyers of calls
2. Sellers of calls
3. Buyers of puts
4. Sellers of puts

People who buy options are called holders and those who sell options are called writers; furthermore, buyers are said to have long positions, and sellers are said to have short positions.

Here is the important distinction between buyers and sellers:
- Call holders and put holders (buyers) are not obligated to buy or sell. They have the choice to exercise their rights.
- Call writers and put writers (sellers), however, are obligated to buy or sell. This means that a seller may be required to make good on a promise to buy or sell.

Don't worry if this seems confusing - it is. For this reason we are going to look at options from the point of view of the buyer. Selling options is more complicated and can be even riskier. At this point, it is sufficient to understand that there are two sides of an options contract.

The Lingo
To trade options, you'll have to know the terminology associated with the options market.

The price at which an underlying stock can be purchased or sold is called the strike price. This is the price a stock must go above (for calls) or go below (for puts) before a position can be exercised for a profit. All of this must occur before the expiration date.

An option that is traded on a national options exchange such as the Chicago Board Options Exchange (CBOE) is known as a listed option. These have fixed strike prices and expiration dates. Each listed option represents 100 shares of company stock (known as a contract).

For call options, the option is said to be in-the-money if the share price is above the strike price. A put option is in-the-money when the share price is below the strike price. The amount by which an option is in-the-money is referred to as intrinsic value.

The total cost (the price) of an option is called the premium. This price is determined by factors including the stock price, strike price, time remaining until expiration (time value) and volatility.


(Do you think options are over your head? They aren't. Read Options And Futures: You Already Trade Them.)

Many people mistakenly believe that options are riskier investments than stocks. This stems from the fact that most investors do not fully understand the concept of leverage. However, if used properly, options can have less risk than an equivalent position in a stock. Let's look at how to calculate the potential risk of stock and options positions and discover how options - and the power of leverage - can work in your favor.

What Is Leverage?
Leverage has two basic definitions applicable to option trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into trouble. A dollar amount invested in a stock and the same dollar amount invested in an option do not equate to the same risk. (To learn about how leverage works with a different type of investment, read Leveraged ETFs: Too Risky For Their Own Good? and Top 5 Reasons To Keep Leveraged ETFs To The Pros.)



The second definition characterizes leverage as maintaining the same sized position but spending less money doing so. This is the definition of leverage that a consistently successful trader incorporates into his or her frame of reference. This is the definition that investors must now understand and embrace.

Playing the Numbers
You may believe that if you are going to invest $10,000 in a $50 stock, you would be much better off investing that $10,000 in $10 options. After all, investing $10,000 in a $10 option would allow you to buy 10 contracts and control 1,000 shares.

Meanwhile, $10,000 in a $50 stock would only get you 200 shares. It is easy to see the obvious disparity here and our greed always is seeking a higher potential for profit. Unfortunately, most investors can't see past that. The problem is that there is another disparity here beyond the obvious difference in the numbers of shares an investor can control: risk. This disparity is not so easily seen by investors blinded by greed. (For more insight, see Trading A Stock Vs. Stock Options - Part 1 and Part 2.)

In the example above, the option trade has much more compared to the stock trade. With the stock trade, your entire investment can be lost, but only with an improbable movement in the stock. In order to lose your entire investment, the $50 stock would have to trade down to $0.

In the option trade, however, you stand to lose your entire investment if the stock simply trades down to the long option's strike price. For example, if you own the 40 strike (an in-the-money option), the stock only will need to trade below 40 by expiration for the entire investment to be lost. That represents only a 20% downward move.

Clearly, there is a large risk disparity between owning the same dollar amount of stocks or options. This risk disparity exists because the proper definition of leverage was applied incorrectly to the situation. To correct this problem, let's go over two alternative ways to balance risk disparity while keeping the positions equally profitable.

Conventional Risk Calculation
The first method you can use to balance risk disparity is the standard, tried and true textbook way. Let's go back to our stock trade to examine how this method works.

If you were going to invest $10,000 in a $50 stock, you would receive 200 shares. Instead of purchasing the 200 shares, you could also buy two call option contracts. This is because one contract is worth one hundred shares of stock. Therefore, two contracts would be worth two hundred shares of stock. By purchasing the options, you can spend less money but still control the same number of shares. The number of options is determined by the number of shares that could have been bought with your investment capital.

For example, let's suppose that you decide to buy 1,000 shares of eBay at $41.75 per share for a cost of $41,750. However, instead of purchasing the stock at $41.75, you could also buy 10 of the January 2008 (in-the-money) 30 strike calls for $1,630 per contract. This option has an 86 delta, which means that it will mimic the performance of the stock to 86%. If the stock trades up a dollar, the option will increase in value by eighty-six cents. The option purchase will provide a total capital outlay of $16,300 for the 10 calls. This represents a total savings of $25,450, or about a 60% of what you could have invested in eBay stock.

Being Opportunistic
This $25,450 savings can be used in several ways. First, it can be used to take advantage of other opportunities, providing you with greater diversification. Another interesting concept is that this extra savings can just sit in your trading account and earn money market rates. The collection of the interest from the cost savings can create what is known as a synthetic dividend. During the course of the life of the option, the $25,450 savings will gain 3% interest annually in a money market account. That represents $763 in interest for the year, equivalent to about $63 a month or about $190 per quarter. Divide the $190 per quarter by the 1,000 eBay shares that you control and you have created the equivalent of a $0.19 quarterly dividend. (For related reading, see The Importance Of Diversification and The Power Of Dividend Growth.)

You are now, in a sense, collecting a dividend on a stock that does not pay one while still seeing a very similar performance (86%) from your option position in relation to the stock's movement. Best of all, this can all be accomplished using less than one-third of the funds you would have used had you purchased the stock.

Alternative Risk Calculation
The other alternative for balancing cost and size disparity is based on risk. We'll refer to this as "Ron's risk calculation."

As you've learned, buying $10,000 in stock is not the same as buying $10,000 in options in terms of overall risk. In fact, the money invested in the options was at a much greater risk due to the potential of a greater loss, even when controlling a smaller number of shares. In order to level the playing field, therefore, you must equalize the risk and determine how to have a risk-equivalent option position in relation to the stock position.

Positioning Your Stock
Let's start with your stock position: buying 1,000 shares of a $41.75 stock for a total investment of $41,750. Being the risk-conscious investor that you are, let's suppose that you also enter a stop-loss order, a prudent strategy that is advised by most market experts.

You set your stop order at a price that will limit your loss to 20% of your investment, which is $8,350 of your total investment of $41,750. Assuming that this is the amount that you are willing to lose on the position, this should also be the amount you are willing to spend on an option position. In other words, you should only spend $8,350 buying options. That way, you only have the same dollar amount at risk in the option position as you were willing to lose in your stock position. This strategy equalizes the risk between the two potential investments.

If you own stock, stop orders will not protect you from gap openings. The difference with the option position is that once the stock opens below the strike that you own, you will have already lost all that you could lose of your investment, which is the total amount of money you spent purchasing the calls. However, if you own the stock, you can suffer much greater losses. In this case, if a large decline occurs, the option position becomes less risky than the stock position.

For example, if you purchase a pharmaceutical stock for $60 and it gap-opens down at $20 when the company's drug, which is in Phase III clinical trials, kills four test patients, your stop order will be executed at $20. This will lock in your loss at a hefty $40. Clearly, your stop order doesn't afford much protection in this case.

Other Options
However, let's say that instead of purchasing the stock, you buy the three-month out $50 calls for $11.50. Now your risk scenario changes dramatically - when you buy an option, you are only risking the amount of money that you paid for the option. Therefore, if the stock opens at $20, all of your friends who bought the stock will be out $40, while you will only have lost $11.50. When used in this way, options are actually less risky than stocks.

Getting back to our eBay example, we will now make our option purchase using the appropriate amount of funds as determined by Ron's Risk Calculation. Keep in mind that the choice of the correct option (month and strike) is also essential to this strategy. For now, we'll look for an in-the-money option with a delta of around 80-85. Let's assume that you believe that the eBay movement will be over in the next couple of months and you want to choose an expiration month that matches the time frame you anticipate the movement will take.

For this example, let's choose the eBay April 37.5 calls with an 82 delta, which is trading at a price of $5.20. Remember, the stock is trading at 41.75 and, therefore, the option is in-the-money. Using Ron's Risk Calculation, you've determined that you can spend up to $8,350, or the amount of money you were willing to lose on a stock purchase as determined by your own stop-loss limit. This will allow you to purchase 16 contracts (at a price of $5.20 per share, each contract would be $520). If you divide the total amount ($8,350) by the amount it costs to purchase one contract ($520), you will get 16.057692 as an answer. This means that you can buy 16 contracts for a total expense of $8,320.

When you compare your stock position and your option position, you will find that you have an equal amount of total dollar risk in both positions; however, your option position will cost you much less in terms of capital outlay - you will control 1,600 shares instead of only 1,000 (a 60% increase). This will likely give you a better percentage return while guaranteeing a fixed limited loss under conditions when a stop order on a stock offers limited protection.

Whether using a conventional risk calculation or Ron's Risk Calculation, determining the appropriate amount of money that you should invest in an option will allow you to use the power of leverage that options can provide while keeping a balance in the total risk of the option position over a corresponding stock position. (For related reading, check out Risk Graphs: Visualizing Your Profit Potential and The Four Advantages Of Options.)

Hedging With Options
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