Nothing in the world is free. Everything has its drawbacks. As profitable as options trading can be, the practice is no exception to this rule. Before you embark on going from trading stocks to trading options, you should know what these risks are.
If you have gone through other sections of this site, you should already have deduced that the movement of options varies more widely than that of the underlying stocks. It is for this very reason that options trading can be highly profitable. If an underlying stock moves only 2% - say, from $50.00 to $51.00 - a typical option for that stock can move from $4.00 to $4.99, or about 25%. Quite an advantage, you think? But by the same token if a stock goes down in value and you have a long position on an option, the percentage you lose will probably be greater than what the percentage loss in the underlying stock is. Gains with options will be bigger, but so will the losses.
If you've visited the section of this site that address shifting deltas, you'll recall that even though your losses will be greater, the risk is often worth the reward. This is because the delta shrinks when going in the negative direction and grows when moving in the positive direction, up to .99 if you're in a long call. So even though you'd lose more than if you were invested in the underlying stock, the reward and risk aren't necessarily the same. For example, the amount that you'd gain - assuming you were invested in the option - if the underlying stock went up $2 is greater than the amount you'd lose than if the underlying stock went down $2. Yes, you could still lose if the stock went down, but given that you could gain more than you could lose if the stock moved equally in both the positive and negative directions, you would probably find options trading more beneficial than stock trading in the long term. If you were invested in the stock, the gains and losses would be the same. If a stock went up $1 and you owned one share, you'd simply gain $1. If it went down $1, you'd lose $1, simple as that. We'll stay away from the math for now and you can do it for yourself when you have time, but you'll notice that the ratio isn't 1:1 with options trading.
Another issue to consider when deciding to trade options is leverage. You can control a large amount of stock with less money by investing in options (see section Why Options?). For this reason, you can greatly reduce your risk exposure because you are putting up less money to control stock that is worth much more than your investment. Instead of risking $5000 of your own money to control $5000 worth of stock, you would be risking much less. This could be as low as around $300. However, if you were to consider investing the same amount of money between stocks and options (say, $10000 in stocks or $10000 in options), then for reasons mentioned above your exposure would be much, much more if you were invested in the options. In this case, you'd be controlling much more than $10000 worth of the underlying stock if you bought $10000 worth of options, even though you've "bought in" for the same amount of money. Your exposure is less only if you decide to control a given amount of stock with less money using options, not if you decide to invest the same amount of money in options.
You should also take into account the spread between the bid and the ask price. This can be as high as .20 depending on the option. Even though you can shave the spread somewhat, it will likely not be as narrow as the spreads for stocks. In this case, you have to "make up" more just to cover the spread. As such, this increases your risk by just a little bit if you decide to trade options.
Generally speaking, the risk level associated with stocks is somewhat overrated. If you invested $7000 in a stock, theoretically your risk would be $7000. Whatever you put in is what you risk, they say. The only way you'd lose all of the $7000, however, is if the stock hit . This isn't entirely impossible, but it is farfetched. What are the chances that a solid company will lose all of its shareholder value? Pretty slim. There are close to 40,000 publicly traded stocks in the United States, and sure, every now and then there comes an Enron or WorldCom, but the odds of investing in such a company are pretty slim. Even so, those stocks took about a year before actually hitting zero despite all the scandals because logistically all shares cannot be liquidated all at one time. Therefore, big shareholders such as mutual funds had to stagger their sales over time. So don't expect many, if any, stocks to lose all value overnight.
More realistically, your actually risk will probably be no more than 50% depending on the stock. If a stock is $100, how low can it really go? If it goes down to $50, then it's already pretty bad. It can perhaps get worse, but the point being made is that rarely is your risk actually 100% when investing in stocks, practically speaking.
Now, given that options do have an expiration date, your risk is 100%. If you do not make a move prior to the expiration date of the option, you will lose everything that you have invested in that option. Options are a very different game than stocks. You cannot simply just let them sit, even if you are a long-term investor. Every now and then you must track the value of your investment. If you are not willing to do so, then you might want to reconsider investing in options. They are a very time-sensitive instrument, and those unwillingly to treat it as such may pay huge consequences. Given all the rewards associated with options, they do require attention in order to reap the benefits. Again, nothing is free. If you want big returns, then you must be willing to closely monitor what you invest in or else all the benefits of investing in options will likely not materialize.
0 comments:
Post a Comment