Why Options are NOT Risky

Capital Preservation is the Key

You may have heard that options are risky, and if used improperly they can be, but in reality options were created to reduce risk. In fact options are used by large investors and hedge fund mangers to protect against unforeseen market changes and to diversify their portfolios.

You can use the options strategies taught and analyzed in the OptionsMastery Suite to harness the risk management power of options for your portfolio. Options strategies can be used whether the market moves up (bullish), down (bearish), or sideways (neutral).

Although buying stock is the most typical way to profit in the markets, it has two significant limitations.

1. Buying stock only generates profits when the stock rises in price.

2. You risk large amounts of capital to control the stock.

To better understand the advantages of option strategies and how they limit your risk, let’s look at various ways to invest in different market conditions.

Bullish Market

Let’s assume that stock XYZ is currently trading at $50. We think that it will go up sharply in price in the next 6 months and we want to control 100 shares to take advantage of the expected increase. Of course, we want to limit our risk if we’re wrong and the stock drops in price. Let’s look at several bullish methods available to us.

Buying Stock – Risky

The most common method of investing in the market is buying stock. When you buy stock, you pay full price for the stock and you only make money if the stock goes up in value. You may lose up to 100% of the stock’s value if it drops in price. (Remember Enron?)

Buying Stock Using Margin – Even More Risky

To increase or “leverage” returns, some people buy stock on margin. In other words, they pay cash for part of the purchase price and borrow the rest (usually 50% of the purchase price) from their broker and pay interest on the amount borrowed. If the stock goes up in price, they get a higher return (minus interest), but if it drops they can actually lose the cash they invested plus the money they borrowed, plus interest. Sounds risky, doesn’t it?

Options – Limited Risk

Using options, you can control that same stock for a small percentage of the stock’s value. In other words, you can control 100 shares of stock without the risk of margin, and if you use the proper option strategies, you can only lose the small amount of capital you initially invested if you’re wrong. Since we are bullish, we would typically use call options. (If you’re new to options, read our introduction, What are Options?

Risk Comparison

The graph below shows the profit and loss curves for buying stock (dashed blue line) and buying a call option (black curve). You can see that you have unlimited possible profit (above the green horizontal line) in both cases, but you can lose all of the stocks value if the stock drops in price, but you can’t lose more than you paid for the call option, which is considerably less.

Bearish Market

Let’s assume that stock XYZ is currently trading at $50. We think that it will go down sharply in price in the next 6 months and we want to profit from the expected drop. Of course, we want to limit our risk if we’re wrong and the stock rises in price. Let’s look at several bearish methods available to us.

Selling Short Stock – Risky

The most common method of profiting in bear markets is selling stock short. In other words, you borrow stock that you don’t own from your broker and sell it in hopes that the price will drop. You can then buy back the stock at a lower price and keep the difference. The problem is that you have unlimited risk, because if the price goes up, you need to buy back the stock at the new higher price, and the sky’s the limit. . Also, since there is so much risk involved, you normally need a large account with lots of cash to cover the risk. Since the stock is borrowed on margin, you also pay interest on the money borrowed and you pay the lender any stock dividends declared during the loan.

Options – Limited Risk

Using options, you can control that same stock for a small percentage of the stock’s value. In other words, you can control 100 shares of stock without the unlimited risk of selling short. If you use the proper option strategies, you can generate huge profits if you’re right and you would only lose the small amount of capital you initially invested if you’re wrong. Since we are bearish, we would typically use put options.

Risk Comparison

For details on how options limit your risk including a profit versus stock price graph for this bearish strategy, request a Free Info Kit

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Capital Preservation

Capital preservation is always the most important part of any investing program! Everyone wants great returns, but making sure that your investment portfolio is secure is even more important. As you have seen, options allow you to risk only a small amount of your capital to make the same dollar returns as buying or shorting stock.

This is a crucial point to understand, since Capital preservation is always the most important part of any investing program! For more details on how you can limit your risk, request our Free Info Kit