How to Manage Risk when Investing in Options

While many would consider investing in options to be a risky proposition, an investor who understands these instruments is much better prepared to meet the challenge of enhancing returns during uncertain times. Options present a world of investing opportunities. Their main power lies in versatility. Options may be used for speculation, hedging and even increasing returns while minimizing risk.

What are options?

Options are simply contracts between a buyer (holder) and seller (writer). This gives the buyer the right (without any obligation) to buy or sell the underlying asset or security at a specific price on or before a specific date. Options trade on most major exchanges.

All options have several features in common. There will be a strike price (the price at which the underlying asset is bought or sold) and an expiration date (the last day on which the contract may be exercised). There will also be a premium, which is the purchase price.

A real life example

Option trades can also be applied to real-world business. For example, suppose someone finds a house they are interested in buying. However, they do not have the money to buy it now. They negotiate with the owner to execute an option contract. This gives them the right to buy this property for a certain price ($200,000) any time within the next three months. In return for this consideration, the holder now pays the owner $2,000.

Now, the owner may not sell this property to anyone but the option holder within the next three months. If oil is discovered on the property, the owner may not sell it to someone else for $3,000,000. On the other hand, if there is a fire or something is discovered which dramatically lowers the property value, the option holder can walk away, losing only the $2,000 paid for the right to hold this option.

The option holder also has other possibilities. They may, of course exercise the option and buy the property for $200,000. Or, they could ‘flip’ the property to another for a higher price (there would be a double closing, with the owner selling to the option holder, who then immediately sells it to the second buyer).

Types of options

There are two types of options. Calls and puts. Calls give one the right (but not the obligation) to buy an underlying asset, while puts convey the right to sell.

An investor will buy a call when they expect the price of a stock to rise. A put will be purchased if they expect the price to decrease. It is also possible to sell a call (or put) which will reverse the desired outcome. When selling a call, for example, an investor is hoping the price either stays about the same or declines.

How to use options

There are two basic ways to use options. The first is speculating. This is what most people commonly think of regarding options. Here, one is simply hoping that the price of the underlying asset moves in the direction they hope within the given time frame. This is certainly risky, since one must be correct about the direction of the price move, its magnitude and even the time frame involved.

Another use of option contracts is for hedging positions already held. If an investor holding a large position in a stock fears the price may decline, they may decide to buy a put. This will allow them to sell their shares at a specified price, capping their potential loss. They may even make a profit doing this. Large institutions do this all the time.

An investor could also use option strategies to make money with little risk. Try selling covered calls. Here, an investor sells a call option on shares of stock which they already own. This is best done when they feel sure that prices will remain stable (or even decrease), and at a strike price above current market. Ideally, the contract will expire worthless and the investor simply keeps the premium. The down side to this is that if the stock price rises above the strike price, the owner will be called out and must sell their shares (of course, they do keep the premium, and they have only lost this potential capital gain).

Many seasoned investors use this strategy regularly to increase their returns substantially. Again, this is best done with solid companies with relative price stability.

Closing out a position

There are several ways to close out an options position or trade. First, it could be allowed to expire worthless (most contracts actually end this way). Second, the option could be traded on the open market. The third possibility is to fulfill the contract. For example, an investor who holds a call option on a stock which has risen above the strike price will actually buy the stock. Typically, the investor will then immediately sell the stock, earning a profit, since the strike price paid is lower than the current market value. This is the least common of all three possibilities.

Investing in options can give investors and traders a great way to manage risk. This is particularly true when used for hedging. There are even safe strategies for earning income with options. Each and every investor should keep themselves informed about such simple and effective ways to boost the performance of their portfolios. Investors should always be aware that pure speculation with options is incredibly risky and that if the stock moves against them, they will likely lose their entire investment; using safer strategies, such as hedging current positions and writing covered calls, in combination with a well-diversified portfolio could help reduce the risk normally associated with options.

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