Stock options can reduce risk

Syvia Poon is a financial analyst and an avid market observer with a particular interest in stock options trading. She explains that beyond their use as speculative trading vehicles, stock options also have a function as hedging vehicles. She also recommends trying the virtual trading platforms or practice accounts available from some brokerages.

Confucius once said, “Success depends upon previous preparation, and without such preparation there is sure to be failure.”

How much preparation is enough to trade stock options successfully? Due to the complex nature of stock options, most people would suggest you stay clear of something most people don’t understand.

On the contrary, I am of the opinion that you may want to understand this incredibly versatile tool used in one form or another by major corporations, financial institutions and the largest wealth-management firms.

I recognize that options can carry higher risk than stocks. However, I believe all investments have inherent risk, and it is up to individual investors to make educated choices based on their own risk tolerance.

Stock options explained

To start off: What is a stock option? It is a contract that represents the right to buy or sell an underlying stock at a specific price on or before a certain date. It is important to note that the option gives the buyer the right, but not the obligation, to buy or sell the stock as per the terms of the contract.

Here are some of the basic terms in common use on the stock options market:

■ A “call” gives the investor the right to buy an underlying asset at a set price before the expiry date;

■ A “put” allows for the right to sell an underlying asset at a set price before the expiry date.

The “expiry date” (or “expiration date”) is the date up to which the option can be exercised (in the case of North American options; European options can only be exercised on the expiry date);

■ “Exercise” is the act of using an option to buy or sell stocks;

■ An “underlying asset” is the asset to which an option is tied; usually this is a stock or index;

■ A “contract” is the unit by which options are bought and sold. Each contract represents an option to exercise for 100 shares of stock.

■ A “premium” is the price of an option as determined by stock price, time to expiry (also known as time value), and volatility (a stock price’s fluctuation). Premium prices are listed per share and must be multiplied by 100 to obtain the price of one option contract, and;

■ The Chicago Board Options Exchange (CBOE) is a U.S. options exchange hosting publicly-listed options with fixed strike prices and expiry dates. (Note that CBOE deals strictly with U.S. securities, but it enjoys far more trading activity than its counterpart in Montreal, the Canadian Derivatives Exchange.)

Based on my own experience, I will try to enhance your preparations for options trading by pointing out what I didn’t know when I jumped in too soon.

The first time I encountered the concept of stock options was when I came across a blog series detailing a daily options trading strategy. This strategy was particularly engaging to my analytical mind because it was based on technical trading.

The premise appeared straightforward: using a set of five technical metrics, you buy your options when all five criteria fit within a certain range. Then, you sell your options and profit by the end of day.

I spent lots of time verifying the strategy and it seemed to check out. Even better, the strategy used a lot of the high-flying stocks that I was already familiar with trading.

I also learned that I could use options to profit on speculation that a stock would drop. For example, buying a “put” would allow me to do this with much less risk than simply shorting a stock.

Put option

A short sale involves borrowing shares from a broker and immediately selling them on the market. To make a profit, the stock price must decrease, allowing the investor to buy them back at a lower price and return the shares to the broker.

Should the stock price increase, short-selling a stock presents a limitless loss of downside since a stock could potentially rise infinitely. On the other hand, purchasing a put option would restrict my loss to the cost of the option.

Call option

If you think a stock would increase, you could buy a call option. Why would one buy a call option instead of the stock itself, you might ask?

Since call options cost a fraction of the price of the underlying stock, you stand to profit (and also lose) a lot more with this leverage.

So far we’ve only talked about speculation, which was what I was too focused on as a novice trader, eager to make big profits.

Using stock options as a hedging tool

In fact, options can be used as a great hedging tool. For example, if you own a stock but are worried about a downturn, you can purchase a put option for that stock.

If the stock goes up as you had hoped, you will make a profit minus the small premium you paid for the put option. However, if the stock goes down, your losses would be offset by the increase in value of the put option that you bought. This strategy is commonly known as a protective put.

Obviously, I have only explained some of the basics. I would caution it is best to perform your own research and lots of it as your preparation for success. Some brokerages offer virtual trading platforms, which I highly recommend using, to allow you to become familiar with the process and try out strategies before risking any of your hard-earned money.

Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846

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