Is Options Trading 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.

Reducing Risk with Options

Options traders have the ability to buy and sell options. The majority of Options expire worthless. Selling options is like an 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 mitigate risk by selling options with a strike price that is further away from the stock price. In this way you create a vertical spread.

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

 

Less Risk with options

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.

If in you would have sold an put with a strike price of 53 you would have received the option premium upfront. And since the stock price went to $60 you could have kept the entire premium. If the stock price did not move at all you could have kept the premium. In case you bought the call you lost $600. If Facebook went down to $53.01 at expiration in case you sold an 53 put you still can keep the entire premium! Only below $53 the put seller is at risk.

 

Put vs Stock Comparison

My favorite financial network tastytrade did a comparison between a put and a stock. 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 selloptionpremium.com we typically sell options. We receive option premium at the sale and reduce the risk when we sell out of the money options. If we trade expensive stocks we sell options spreads instead of naked options. By taking profits early we make sure that profits does not run away.

 

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