Controlling Risk With Options

Many investors mistakenly believe that options are always riskier investments than stocks because they may not fully understand what options are exactly and how they work. Options, in fact, can be used to hedge positions and reduce risk, such as with a protective put. Options can also be used to bet on a stock going up or down, but with relatively less risk than owning or shorting the actual equivalent in the underlying stock. This latter use of options to minimize risk in making directional bets will be the focus of this article. Read on to learn how to calculate the potential risk of options positions and how the power of leverage can work in your favor.

Options and Leverage

Let us first consider the concept of leverage, and how it applies to options. Leverage has two basic definitions applicable to options 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 the most trouble. A dollar invested in a stock, and the same dollar invested in an option does not equate to the same risk.

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 or investor incorporates into their frame of reference. 

Interpreting the Numbers

Consider the following example. You're planning to invest $10,000 in a $50 stock but are tempted to buy $10 options contracts as an alternative. After all, investing $10,000 in a $10 option allows you to buy 10 contracts (one contract is worth one hundred shares of stock) and control 1,000 shares. Meanwhile, $10,000 in a $50 stock will only buy 200 shares. 

In this example, the options trade has more risk than the stock trade. With the stock trade, your entire investment can be lost but only with an improbable price movement from $50 to $0. However, you stand to lose your entire investment in the options trade if the stock drops to the strike price. So, if the option strike price is $40 (an in-the-money option), the stock only needs to drop below $40 by expiration for the investment to be lost, even though it's just a 20% decline.

There is a huge risk disparity between owning the same dollar amount of stocks and options. This risk disparity exists because the proper definition of leverage was applied incorrectly. To correct this misunderstanding, let's examine two ways to balance risk disparity while keeping the positions equally profitable.

Conventional Risk Calculation

The first method to balance risk disparity is the standard and most popular way. Let's go back to our example to see how this 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. By purchasing the options, you spend less money but still control the same number of shares. In other words, the number of options is determined by the number of shares that could have been bought with the investment capital.

Say you decide to buy 1,000 shares of XYZ at $41.75 for a cost of $41,750. However, instead of purchasing the stock at $41.75, you can buy 10 call option contracts whose strike price is $30 (in-the-money) for $1,630 per contract. The options purchase will incur 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 would have paid buying the shares.

This $25,450 savings can be used in several ways. First, it can take advantage of other opportunities, providing you with greater diversification. Second, it can simply sit in a trading account and earn money market rates. The collection of interest can create what is known as a synthetic dividend. For example, if the $25,450 savings gains 2% interest annually in a money market account. During the option's life span, the account will gain $509 interest per year, equivalent to about $42 a month.

You are now, in a sense, collecting a dividend on a stock that may not pay one while also benefiting from the options position. Best of all, this can be accomplished using about one-third of the funds needed to purchase the stock outright.

Alternative Risk Calculation

The other alternative for balancing cost and size disparity is based on risk. 

As we've learned, buying $10,000 in stock is not the same as buying $10,000 in options in terms of overall risk. The options exposure carries much greater risk due to greatly increased potential for loss. To level the playing field, you must have a risk-equivalent options position in relation to the stock position.

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

You set a stop order at a price that will limit your loss to 20% of the investment, which calculates to $8,350. Assuming this is the amount you are willing to lose, it should also be the amount you are willing to spend on an options position. In other words, you should only spend $8,350 buying options for risk equivalency. With this strategy, you have the same dollar amount at risk in the options position as you were willing to lose in the stock position. 

If you own stock, stop orders will not protect you from gap openings. With an options position, once the stock opens below the strike price, you have already lost all that you can lose, which is the total amount of money you spent purchasing the calls. If you own the stock, you can suffer a much greater loss, so the options position becomes less risky than the stock position.

Say you purchase a biotech stock for $60, and it gaps down at $20 when the company's drug kills a test patient. Your stop order will be executed at $20, locking in a catastrophic $40 loss. Your stop order didn't afford much protection in this case.

However, say you pass on stock ownership and instead buy the call options for $11.50. Your risk scenario now changes dramatically because you are only risking the amount of money you paid for the option. Therefore, if the stock opens at $20, your friends who bought the stock will be out $40, while you will have lost $11.50. Options become less risky than stocks when used in this manner.

The Bottom Line

Determining the appropriate amount of money to invest in an options position allows the investor to unlock the power of leverage. The key is maintaining balance in the total risk is to run a series of "what if" scenarios, using risk tolerance as your guide.