Over the long-term investing in stocks can be profitable. But stock investing can be risky over the short term due to market fluctuations and over the long term when an investor does not have a strategy for hedging risk. Options provide both leverage for trading capital and ways to limit risk. How to control risk with options begins with understanding just what options are and then the various option trading strategies that professionals commonly use to hedge risk.
What Are Options?
Options are broken down into calls and puts. A call contract gives the buyer of the option contract the right to purchase the underlying stock at a fixed price specified in the contract and called the strike price. This right lasts for the duration of the option contract. The buyer is under no obligation to buy the stock and will only do so if the market price rises above the strike price. Most commonly a trader will exit the contract for a profit rather than purchase the stock in question. The buyer of a put pays a premium for this option whereas the seller receives the premium. The seller has no choice but to sell the stock in question if the buyer executes the contract.
A put contract gives the buyer the right to sell a stock at a price specified in the contract, which is the strike price. This right lasts for the duration of the option contract. The buyer has no obligation to sell the stock in question and will only do so if the market price has fallen below the strike price. As with calls, put buyers are as likely to exit their contract for a profit as to actually sell the stock in question. The seller of the put is obligated to buy the stock if the buyer executes the contract.
Risk Control with Call and Put Options
A simple example of how to control risk with options is this. A person believes that a stock is likely to go up in price. However, the market is volatile and the potential buyer is not certain that the stock price might not fall before rising. By purchasing a call of the stock in question the person uses less money than if they had purchased the 100 shares that are covered by a call option. The premium paid for this call contract, plus commissions and fees, is the limit of the risk incurred by the person buying the call contract. The stock price, as feared, falls instead of rising. A person who purchased 100 shares of stock may lose a substantial amount of money whereas the buyer of a call option will only lose the option premium.
The case is similar when buying puts. The person believes that the price of stock might fall. This person may have bought the stock years before and seen its price rise significantly in a bull market. They do not want to sell because the bull market may not be over yet but they want to protect themself in case the price drops. The person avoids the risk of missing out on a continued rally by purchasing a put on the stock. If the stock goes up instead of down the buyer has only lost the premium they paid. If the stock does fall significantly in price, they can either sell at the strike price instead of the now-lower market price or simply take their profit by exiting the contract and keep the stock in hopes of another rally.
Option Trading Strategies to Hedge Risk
At Top Gun Options we routinely preach that one must always hedge risk in every trade. A basic strategy that we often use to profit from a short term fall in price is a bear call spread. This approach consists of selling a call at one strike price and buying a call at a higher strike price. This setup provide a credit when it is set up and that credit is the total profit if the stock price remains steady or falls. If the price of the stock does go up the loss is limited by the purchased call at the higher price. With this and many other risk-hedging strategies, a person can repeatedly take moderate profits without ever incurring the risk of the sort of major loss occasionally seen when selling options.
To learn more about how options work for controlling risk sign up for one of our training sessions and then consider joining one of the trading squadrons at Top Gun Options where we routinely profit in both rising and falling markets.