How Options Can Mitigate the Risk of Investing in Stocks

How Options Can Mitigate the Risk of Investing in Stocks

Many investors rely on options to round out their portfolios. While options have traditionally been considered risky investments, investors who understand these risks can use them to accomplish a number of financial goals. As with futures, options can be used to hedge against declines in the market and to minimize losses, as well as to speculate on future market trends. When used as part of a larger investment strategy, options can prove worthwhile for both conservative investors and those who are comfortable taking risks. At the same time, options are complex and can be risky if utilized in an improper way, so investors should take time to learn about them thoroughly before making any investments.

What Exactly Is An Option?

stocksAs its name implies, an option provides a right—but not an obligation—to purchase or sell an underlying security at a later date and at a certain price. Options are derivative securities with a price that is intrinsically linked to another asset. A call option refers to the right to buy, while a put option refers to the right to sell. While investors who are familiar with futures will recognize a number of similarities between the two derivatives, the key difference is that futures give you the obligation—while options only provide the right—to buy or sell securities.

Purchasing an option involves a premium, which refers to the cost of the options contract. This upfront investment provides you with the right to make a purchase at a given price in the future. For example, imagine that a developer wants to lock in a piece of land at a certain price, but knows that construction cannot begin unless a new zoning law is passed. The developer may purchase an option for a fraction of the purchase price and then pay the desired price in the future if the zoning law passes. If the zoning law does not pass, then the developer loses the premium, but does not have a piece of land that is unusable. On the flip side, the land may have doubled in value since the options contract was purchased, but the lower price is already locked in, which represents the put option.

Call Option Resembles An Insurance Policy

A call option resembles an insurance policy. Imagine that you own several stocks and hears that a recession could occur in the next couple years. If you want to limit your losses to 10 percent, you can purchase the right to sell at 90 percent of the current value at any time in the next couple of years. Then, if the market does crash, your total losses will be mitigated. However, you would still need to pay a premium that will be lost if the market does not drop.

Investors can also sell options. In this case, sellers are known as writers. As writers of options, you have an obligation to buy or sell if the call or put holder so desires. While the writers always make the money involved with the premium, they also accept a great deal of risk with the obligation to sell.

What Is the Relationship Between Options and Risk?

Many people think of options as inherently risky. Indeed, these derivatives can be used in a way that involves a significant amount of risk. Investors who are less averse to risk may use options in a speculative capacity, which means that they are betting on the market to move in one direction or another. For example, a speculator might believe that a stock will quickly increase in value. The speculator could then buy a call option at a fraction of the price of the stock. If the stock does increase in value, then that person can exercise the right to purchase at a lower price and immediately sell the stock for a profit at the current trade value. This approach is risky because there is no guarantee that the stock will actually go up in value, and the premium could be lost. A string of bad calls could result in a lot of lost money.

However, savvy investors understand that options can actually be used to mitigate overall risk. One strategy that people often use in their IRAs and Roth IRAs is “covered call writing.” This strategy leverages options to make purchasing stocks less risky. First, individuals purchase shares of a stock, then sell call options against the shares that they purchase. Investors can also purchase call options against stock that they already own or for exchange-traded funds.

In order to illustrate the concept of covered call writing, imagine that you purchase 100 shares of stock A for $50 per share. Now, this stock is trading at $60 per share, which means that you have an unrealized gain of $1,000. You can write an option at $60 per share, which earns you an immediate premium. If the stock falls below $60, then you keep the premium, and the option will not be exercised since the stock can be purchased more cheaply on the market. However, if the stock rises, then that $1,000 gain is realized, plus the premium. While selling the stock at a higher price could earn you additional income, the strategy is profitable regardless of the outcome.