Are options risky?

Trading RiskyWhatever you do there is a risk. In some decisions there are more risk involved than others. This counts also for trading, whether you trade stocks or options. When you buy stocks all your money you bought the stock for is on the line. However when you buy an option it is in essence like an insurance.  Would you consider an insurance for your car or home to be risky?  You run the risk of losing your premiums if you don’t make a claim.  But, in exchange for those premiums, you get the comfort of having protection life’s most important assets. Buying options allows you to protect the assets in your portfolio – which is another one of your important assets.

Options traders have the ability to buy and sell options.  In the case of selling options, you would be the one providing the insurance – the insurance company.  In exchange for providing protection, you collect a premium.  But it’s important to realize that the buyer’s protection is the sellers risk. If you do not mitigate your risk you could be exposed to significant risks. You can sell options with a strike price that is further away from the stock price.

Let us look at the following example Facebook is trading at $55,  The option price of a $60 Strike March call is $3. The stock prices moves up to $70 by expiration. We compare the performance of the stock with the call:

Stock will gain $15 ($70-$55) that is an rise 27%

The Call option will gain $7 that is a 233% ($70-$60-$3) move

Therefore, given the scenario above, an investor would spend $5,500 to buy 100 shares of Facebook and realize a gain of $1,500. An option trade that buys only 2 call contracts (of 100 shares each) and spend $600 ($3 X 100 shares X 2 contracts) He/she realizes a gain of $1,400 ($7 X 100 shares X 2 contracts) which is about the same gain as the stock investor who spent $5,500! The worst thing that can happen to the option trade is that he loses his $600 investment.

My favorite financial network tastytrade did a comparison between a put and an option. They  show that Historically, selling an ATM put has been a better strategy than buying 100 shares of stock. The main reason is that the credit received from the put gives the trader more opportunity to be profitable. In the past, the comparison has been based on profit per day, average profit per trade, and win rate.

At we like to sell options. We receive option premium at the sale and like to reduce risk to sell out of the money options, or with expensive stocks we sell spreads. By taking profits early we make sure that profits does not run away.


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