Tuesday, June 2, 2009

MythBusters- Are options riskier than stock?

The fifth and final installment to our Options Myths series will cover:


Myth #5: Options are riskier than stock-

Due to the myriad of strategies one can trade with options, it is impossible to make a general statement that options are riskier than stock. It depends completely upon how you use options.

Options are merely tools. Although some use them to speculate or take on risk, others use them to reduce or hedge off risk. Due to the leverage inherent with options, it is quite easy to blow up an account when they're used improperly. This option myth is probably fueled by the occasional inexperienced option trader who loads up on an exorbitant amount of call or put options in an effort to amass large profits. All too often these traders lack any semblance of a sound money management plan and blatantly disregard the drawbacks of leverage. In short, they commit financial suicide.

Are there certain scenarios where trading options could be considered more risky than stock? Absolutely. We'll explore one such scenario in a minute. But there are also a plethora of situations where options can be used to reduce risk (covered calls and protective puts being two obvious ones).

Suppose I'm bullish on IBM, currently trading at $107, and am considering buying 100 shares of stock. My total capital outlay would be $10,700. The theoretical risk would be the entire $10,700 (this is of course assuming you would be stupid enough to ride the stock all the way to zero) and the potential reward is unlimited.

Scenario #1: The SMART idea.

Now, instead of tying up $10,700 of capital to control 100 shares of stock, I could buy ONE October 105 Call for $880. This call option gives me the ability to control the same 100 shares of stock at a DRASTICALLY lower cost. I then have the option of using the other $9,820 in whatever manner I want. I could merely place the cash in an interest bearing account for the duration of the trade, or use it for other strategies. Because my maximum risk is $880, this is a scenario where using options is much less risky than buying stock.

Scenario #2: The STUPID idea.

Instead of using the $10,700 of capital to buy 100 shares of stock, why not just use the same $10,700 and buy as many call options as possible? Well at $880 a pop, I could buy around 12 contracts ($880 x 12 = $10,560). Some erroneously assume that since they are paying the same amount of money, they have the same amount of risk. WRONG! To lose the $10,700 in the stock trade, IBM must fall to $0 (hehe.. yeah right). To lose the $10,700 in the option trade IBM only needs to reside beneath $105 at Aug expiration. There is a MUCH higher chance of losing your money in the call option trade. Furthermore, by buying 12 contracts you now control 1,200 shares... not 100.

Scenario #2 presents a good example of how an improper use of options and their leverage can present more risk than buying stock outright.

Bottom Line: It's fair to say that the biggest risk of all is ignorance. With proper education and application, options serve as superb vehicles for minimizing risk and are indeed less risky than stock. If you're interested in learning of other asset classes, such as bonds, be sure to check out Surety Bonds.

Tyler-

1 comment:

Mike said...

Well said. The biggest risk of all is ignorance. With proper education and application, options serve as superb vehicles for minimizing risk I do agree with you.
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