As an advisor who specializes in using options to grow and protect clients' assets I've been asked by a few clients if using options in their accounts is too risky of a trade for them since they want to keep any losses to a minimum. In each instance I've easily been able to reply that when used correctly, options actually reduce downside risk. Options got a bad reputation when they first started becoming more mainstream in the 1980s and then even more so when individual investors had greater access to trading options in the 1990s with the growth of the Internet and discount traders. Some adventurous traders jumped in and took advantage of the enormous amount of leverage available through options and after overextending themselves lost money fast on each downturn in the markets. Those of us who took the time to study the best ways to use options to reduce risk found options to be a valuable tool in managing the risk and reward balance.
Options come in two forms, calls and puts. Call options give buyers the ability to purchase contracts that allows them to pay a premium up front to keep the right to buy the underlying stock at a set price (aka the strike) for the length of the contract. Sellers of calls get to keep the premium no matter what, but could be forced to sell the underlying stock at that strike if the stock rises above it. In other words, the stocks shares could be "called away" from the owner. Puts work in the other direction. Put options give the buyers the ability to purchase contracts that allow them to pay a premium up front to buy the right to sell shares of a stock at the strike, no matter how low the stock price drops. This is like buying insurance on your car or house. You pay each period to insure that you don't lose everything, but if you never lose then the premium only gave you piece of mind, but not anything tangible. Sellers of puts are like insurance companies. They collect premiums each period, but have to be able to buy the shares of the underlying stock if they drop below the strike and the shares are "put to" them. If the stock does not drop, they keep the premiums and are not forced to buy the shares.
The risks from calls and puts come from when they are used in excess. Think of a call buyers whose stocks do not rise before the contract expires. They lose 100% of their investment. The same is true of put buyers if the stocks don't fall, the entire investment is lost. If investors use this leverage without regulating their exposure then their portfolio could be decimated in months where they do not choose the direction of their stock picks correctly.
The reduction of risk comes in a few different forms. Buying a put when you own a stock already gives you a hedge or downside protection from a loss as in the insurance example I used above. Buying a call instead of buying the actual shares of stock gives you limited downside risk (only the amount paid for the contract) and unlimited upside potential. Selling a call while owning the shares of stock in advance gives you some of your planned profit in advance in the form of the premium received. If the shares are not called away, then you have essentially reduced your cost per share by the premium amount and can do the same trade again when the first contract expires. Selling a put is very similar to selling a call in the risk reduction. Your upside potential is limited to the amount of premium you receive, but your downside risk is reduced by the amount of the premium you received for selling the option. If you are a put seller you have to think the underlying stock is valued close to correctly where it trades at the time of your sale. If you are forced into buying the shares you have then done so at a reduce price. It can be like leaving a limit order in to buy shares if they drop, but in the case of selling a put you make a profit even if the shares stay flat or do not drop.
Selling calls and puts can create a steady income stream with the amount of income varying based such factors as how close to the current stock price the option's strike is set, how volatile the underlying stock is and the duration of the option's contract. Using options as part of a balanced portfolio can increase potential profit and smooth out the dips. By adding these advantages, the risk of reducing upside potential can be introduced. This is a brief overview of options and the risks they impose.
Talk to your AF Capital Management Advisor to see what options could work best for you.
