In recent articles (Options Basics, Options Leverage) I’ve discussed using options to boost your leverage and reduce capital requirements on making a big play. Options, while risky, can limit the amount of cash you need to put into a trade and can allow you to use your available cash to highly leverage your position without taking on debt via a margin approach.
Options aren’t only useful for increasing your potential gains though, they can also be used to mitigate your losses. Options are used by most investors as a hedge, a means to limit their risk in significant positions. There are more kinds of risk than there are investments, since every instrument carries several kinds of risk, but as an active investor, one must realize that risk isn’t inherently bad. Without risk there would be fewer opportunities for profit.
The main risk in any type of investing and especially in securities is price uncertainty. No one knows for sure whether Google’s stock price (GOOG) will be higher or lower tomorrow, let alone a week or a month from now.
Options, like futures or bonds, carry an additional risk - at some point, from a day to several months or years, they expire. On or any time before that date, the holder has to decide whether to sell the contract, exercise the option to buy, sell the underlying asset, let the option expire worthless.
Each of these options carries implications for gain or loss. Execute or sell an options contract too early and you risk losing any upward movement in the price after you sell. Execute or sell too late and you take the brunt of the time decay and put yourself at risk for negative movements in the stock price.
Complicating the price and timing risks of options is their volatility risk. It is uncertain, on any given day, how much the price will vary and how rapidly.
Ironically, options themselves are forms of risk management. Since the underlying asset has inherent risks as an investment, buying options allows holders to compensate for them.
The leverage of options is one form in which options help you, as an investor, manage risk. Leverage is the ability to control more than you own. Suppose you want to purchase a 100 shares of Google. At the current market price that’s an outlay of around $51,575 (excluding commissions). That’s a hefty sum for the average investor.
But you can control 100 shares of GOOG without owning them for about 1/50th of the cost - currently around $1050 - the price of one option. (One options contract typically is written on 100 shares.)
How is that a form of risk management? The reason is there’s another kind of risk: principal risk. I.e the risk of losing (all or part of) your investment. (Actually this is a form of price risk.)
Purchase a 100 shares of GOOG and you stand to lose $51,150 in the (very unlikely) case that Google goes bust. (Unlikely, but not impossible. Rapid shifts in technology or other factors have tanked more than one high-tech stock).
Purchase one option instead and your principal risk is limited to the $1050 cost of the option.
This is one way to hedge, but isn’t the most common usage for options in regards to risk management. Another approach to managing your risk is to hedge your existing long position in an underlying stock. Lets assume you worked for Microsoft in the 80’s and 90’s and built up a considerable position in the company’s stock. You may not want to sell your stock for one reason or another (tax implications, confidence in the company, etc), but you realize its irresponsible to leave so much of your nest egg in one company. One method that will allow you to retain your long position is to offset your risk by buying some put options. Buying a put will allow you to sell 100 shares of your underlying stock at a given price up to an including a given date. If you have 1000 shares of Microsoft stock, equating to nearly $30,000 dollars, you could currently buy January 2009 $27.50 puts for $2.75 (meaning $275.00). Basically, for $2750, you can sell all your stock in January 2009 for 27.50 a share. That equates to about $5000 less than the price you could currently get, but risk management is all about mitigating risk. Having the puts sets the ‘floor’ at which you can sell your stock. If microsoft stock is at $20 in Jan. 2009, you can still sell your stock for $27.50 per share. In this example, your $2750 investment protects you from losing $10000 if the price of microsoft’s stock declines by $10/share in the next 16 months. You may not want to put all 10 puts to protect all 1000 shares, but you get the point. You can offset some of your risk and set a floor at which you can sell your stock at a given price in the future. Interested in hedging but don’t want pay $2750 to protect it? Buy a $22.50 January 2009 call for only 1.05. Basically, for just over $1000, you’ll have the right to sell your Microsoft stock for $22.50/share anytime in the next 16 months. Think of it as insurance, its protecting against catastrophy. Will your car insurance to protect your $30,000 car cost you more than $1000 for the next 16 months? Quite possibly. Shouldn’t you have the same level of insurance on your retirement portfolio?
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