Controlling Risk With Options

Many investors commonly believe that options are always riskier investments than stocks. However, traders may use options to hedge positions and reduce risk, such as with a protective put. Options can also be used to minimize risk when making directional bets.

Options and Leverage

The concept of leverage can apply to options with two basic trading definitions. The first defines leverage as using the same amount of money to capture a larger position. This is the definition that gets investors into the most trouble. A dollar invested in a stock and the same dollar invested in an option do not equate to equal risk.

The second definition characterizes leverage as maintaining the same-sized position but spending less money. This is the definition of leverage that a consistently successful trader or investor generally incorporates into their strategy. 

Interpreting the Numbers

Suppose an investor puts $10,000 in a $50 stock but is tempted to buy $10 options contracts as an alternative. Investing $10,000 in a $10 option allows the investor to buy 10 contracts and control 1,000 shares. Meanwhile, $10,000 in a $50 stock will only buy 200 shares. 

In this example, the options trade has more risk than the stock trade. With the stock trade, the entire investment can be lost, but only with a price movement from $50 to $0. However, investors lose their investment in the options trade if the stock drops to the strike price. If the option strike price is $40 (an in-the-money option), the stock only needs to drop below $40 by expiration for the investment to be lost, even though it’s just a 20% decline.

There is a risk disparity between owning the same dollar amount of stocks and options because the proper definition of leverage is used incorrectly. To correct this misunderstanding, investors must balance risk disparity while keeping the positions equally profitable.

Conventional Risk Calculation

An investor using $10,000 for a $50 stock would receive 200 shares. Instead of purchasing the 200 shares, they could buy two call option contracts. By purchasing the options, they spend less money but still control the same number of shares. In other words, the number of options is determined by the number of shares that could have been bought with the investment capital.

Suppose an investor buys 1,000 shares of XYZ at $41.75 for $41,750. However, instead of purchasing the stock at $41.75, they can buy 10 call option contracts whose strike price is $30 (in-the-money) for $1,630 per contract. The options purchase will incur a total capital outlay of $16,300 for the 10 calls. This represents a savings of $25,450, or about 60% of what they would pay buying the shares.

This $25,450 savings can be used in several ways. It can take advantage of other opportunities, providing greater diversification, or sit in a trading account and earn money market rates. The interest can create what is known as a synthetic dividend. If the $25,450 savings gains 2% interest annually in a money market account, the account will gain $509 interest or about $42 a month.

Alternative Risk Calculation

With this strategy, the same dollar amount at risk in the options position is the same amount the investor can lose in the stock position. Assume the investor buys 1,000 shares at $41.75 for a total of $41,750. Being a risk-conscious investor, they also enter a stop-loss order, a prudent strategy advised by market experts. They set a stop order at a price that will limit loss to 20% of the investment, which calculates to $8,350. The investor should only spend $8,350 buying options for risk equivalency.

With stock, stop orders will not protect investors from gap openings. With an options position, once the stock opens below the strike price, investors have already lost all that they can lose, which is the total amount of money spent purchasing the calls. Owning the stock exposes the investor to greater loss. The options position is less risky than the stock position.

If an investor purchases a biotech stock for $60, and it gaps down at $20 when the company’s drug fails, the stop order will be executed at $20, locking in a catastrophic $40 loss. However, if the investor buys the call options for $11.50, the risk scenario changes dramatically because they are only risking the amount of money you paid for the option.

The Bottom Line

Determining the appropriate amount of money to invest in an options position allows the investor to unlock the power of leverage. The key to maintaining balance in the total risk is to run a series of “what if” scenarios, using risk tolerance as a guide.