ArtsAutosBooksBusinessEducationEntertainmentFamilyFashionFoodGamesGenderHealthHolidaysHomeHubPagesPersonal FinancePetsPoliticsReligionSportsTechnologyTravel

How Options Can Lower Your Risk

Updated on April 29, 2016

How Optoins Reduce Your Risk

Source

Introduction

The financial crisis has made it much more difficult to make money in the stock
market. The risks have increased dramatically. But this article will show you
how options can lower your risk. But you have heard from a friend of a friend
that their Aunt Sally has lost all of her money with options. So it seems silly
to say how options can lower your risk when you heard about the plight of Aunt
Sally. So which is right?

Both Are Correct

In truth they are both correct situations. If you are not familiar with options
and you simply dabble in them to see what will happen, chances are good that you
will lose the money you have invested. But learn the correct ways to apply
options and you will see how options can lower your risk.

Options Survey

Do You Believe Options Can Be Used to Reduce Your Risk?

See results

What are Options?

So what is an option? Describing what options are is involved and would take a whole other article to do so. That is exactly what I did with "What Are Financial Options?". If you are not familiar with the concept of options this Hubpage will not make much sense without reading that introductory piece.

Options Trading on Amazon

How Do Options Lower Risk?

So getting back to how options can lower your risk. For this first example, I am
going to use call options as my examples for the purpose of this page as they
are usually easier for people to grasp and I won't have to go back and forth
about the differences between a call and a put. Essentially, put options have
an almost opposite effect than a call option with respect to how they react to
the stock price.

Options Are Leverage

Options are a levered product. That means you pay a small premium to control a
large movement in the stock price. So the idea is that you pay a very small
price to participate in the upside of a stock price movement. Let us use a real
world example. At the time of this writing, Apple stock was around $584. What
if I told you that you could buy Apple stock for $33.50 per share? Would you be
interested? You are not really going to get ownership of the stock for $33 but
you can participate in the same movement that Apple stock owners do. You do
this by buying a call option on Apple three months out. At the time of this
writing a 580 call could be yours for $33.50.

Risk Management in Options Trading

Is It a Fair Price?

Whether or not the call option is a fair price at $33.50 is a topic way beyond
the scope of this article. But the leverage is there for you to take advantage
of. You will also need to be aware that the stock must move in the right
direction, i.e., up, in order for your position to profit.

How Exactly Did We Reduce Risk?

Why did this example show how options can lower your risk? Had you bought the
stock outright, you would be risking $584 per share rather than $33.50. You
have much less on the line with the options than with the stock. But, and this
is huge, your option is going to expire in three months. If the stock stays
stagnant within that three month period you lose the entire $33.50 per share.
That is a crucial concept that many do not take into account. What many options
traders will do is to monitor the position after a few weeks and if they see
that it is not moving in the desired direction they will close out the option
and take a much smaller loss than had they held it to expiration. This is an
example of proper risk management.

Options Opinion Poll

Do You Use Options for Speculation or For Reduction of Risk?

See results

Hey! What About Put Options?

Another way options can be used is with put options. If you recall a put option gives the holder the right to sell (put) shares of an underlying stock in the hands of the holder. This concept is usually a bit more difficult for beginners to grasp as it entails selling something that seemingly you don't own. But remember that a put owner profits in the drop of a stock. So the can buy the stock in the market for lower that the strike price that they contracted on. The profit is the difference.

How to Invest in Options

Portfolio Protection

Let's suppose someone wanted to protect a part of their portfolio against a general market drop. They could buy a put on a stock that represents a particular segment of the market. There are many ways to do this but one popular way is to buy puts on an Exchange Traded Fund (ETF) that represents a market segment. Not all ETFs are optionable. But one that does is for the S&P 500 which has the symbol SPY, a.k.a. the spider. At the time of this writing SPY was trading at around $136. You could buy a put option with a 140 strike three months out for around $7. Now again, this article is not about whether that $7 is overpriced, under priced or fairly priced. It is simply to show you that leverage helps you protect your portfolio (it can work for protecting a position on a stock you are holding as well). You only pay $6 (x 100 as each contract is for 100 shares). The put is a hedge against the market dropping. You are participating (at least partially) on the downside that the market makes.

Puts Expire Just as Calls Do

As with the call, you have three months for the market to drop in order to cash out of this contract. But people who hedge their portfolios are not hoping for a drop in the market. They just use the puts for protection in the event that it does.

And Lastly, A WARNING!

Hopefully this article has helped show you how options can reduce your risk. It should be noted that this is no way a recommendation to begin trading options. Used incorrectly and they can actually increase your risk and they are definately not suitable for everyone. You must learn about options extensively and it is advisable to paper trade any kind of strategies before implementing them. I cannot stress this enough!

Comments

    0 of 8192 characters used
    Post Comment

    No comments yet.

    working

    This website uses cookies

    As a user in the EEA, your approval is needed on a few things. To provide a better website experience, hubpages.com uses cookies (and other similar technologies) and may collect, process, and share personal data. Please choose which areas of our service you consent to our doing so.

    For more information on managing or withdrawing consents and how we handle data, visit our Privacy Policy at: https://hubpages.com/privacy-policy#gdpr

    Show Details
    Necessary
    HubPages Device IDThis is used to identify particular browsers or devices when the access the service, and is used for security reasons.
    LoginThis is necessary to sign in to the HubPages Service.
    Google RecaptchaThis is used to prevent bots and spam. (Privacy Policy)
    AkismetThis is used to detect comment spam. (Privacy Policy)
    HubPages Google AnalyticsThis is used to provide data on traffic to our website, all personally identifyable data is anonymized. (Privacy Policy)
    HubPages Traffic PixelThis is used to collect data on traffic to articles and other pages on our site. Unless you are signed in to a HubPages account, all personally identifiable information is anonymized.
    Amazon Web ServicesThis is a cloud services platform that we used to host our service. (Privacy Policy)
    CloudflareThis is a cloud CDN service that we use to efficiently deliver files required for our service to operate such as javascript, cascading style sheets, images, and videos. (Privacy Policy)
    Google Hosted LibrariesJavascript software libraries such as jQuery are loaded at endpoints on the googleapis.com or gstatic.com domains, for performance and efficiency reasons. (Privacy Policy)
    Features
    Google Custom SearchThis is feature allows you to search the site. (Privacy Policy)
    Google MapsSome articles have Google Maps embedded in them. (Privacy Policy)
    Google ChartsThis is used to display charts and graphs on articles and the author center. (Privacy Policy)
    Google AdSense Host APIThis service allows you to sign up for or associate a Google AdSense account with HubPages, so that you can earn money from ads on your articles. No data is shared unless you engage with this feature. (Privacy Policy)
    Google YouTubeSome articles have YouTube videos embedded in them. (Privacy Policy)
    VimeoSome articles have Vimeo videos embedded in them. (Privacy Policy)
    PaypalThis is used for a registered author who enrolls in the HubPages Earnings program and requests to be paid via PayPal. No data is shared with Paypal unless you engage with this feature. (Privacy Policy)
    Facebook LoginYou can use this to streamline signing up for, or signing in to your Hubpages account. No data is shared with Facebook unless you engage with this feature. (Privacy Policy)
    MavenThis supports the Maven widget and search functionality. (Privacy Policy)
    Marketing
    Google AdSenseThis is an ad network. (Privacy Policy)
    Google DoubleClickGoogle provides ad serving technology and runs an ad network. (Privacy Policy)
    Index ExchangeThis is an ad network. (Privacy Policy)
    SovrnThis is an ad network. (Privacy Policy)
    Facebook AdsThis is an ad network. (Privacy Policy)
    Amazon Unified Ad MarketplaceThis is an ad network. (Privacy Policy)
    AppNexusThis is an ad network. (Privacy Policy)
    OpenxThis is an ad network. (Privacy Policy)
    Rubicon ProjectThis is an ad network. (Privacy Policy)
    TripleLiftThis is an ad network. (Privacy Policy)
    Say MediaWe partner with Say Media to deliver ad campaigns on our sites. (Privacy Policy)
    Remarketing PixelsWe may use remarketing pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to advertise the HubPages Service to people that have visited our sites.
    Conversion Tracking PixelsWe may use conversion tracking pixels from advertising networks such as Google AdWords, Bing Ads, and Facebook in order to identify when an advertisement has successfully resulted in the desired action, such as signing up for the HubPages Service or publishing an article on the HubPages Service.
    Statistics
    Author Google AnalyticsThis is used to provide traffic data and reports to the authors of articles on the HubPages Service. (Privacy Policy)
    ComscoreComScore is a media measurement and analytics company providing marketing data and analytics to enterprises, media and advertising agencies, and publishers. Non-consent will result in ComScore only processing obfuscated personal data. (Privacy Policy)
    Amazon Tracking PixelSome articles display amazon products as part of the Amazon Affiliate program, this pixel provides traffic statistics for those products (Privacy Policy)