The Risks & Rewards Of Options Trading
Most strategies that options investors use have limited risk but alsolimited profit potential. For this reason, options strategies are notget-rich-quick schemes. Transactions generally require less capitalthan equivalent stock transactions, and therefore return smaller dollarfigures - but a potentially greater percentage of the investment - thanequivalent stock transactions.
Eventhose investors who use options in speculative strategies, such aswriting uncovered calls, don't usually realize dramatic returns. Thepotential profit is limited to the premium received for the contract,and the potential loss is often unlimited.
While leverage means thepercentage returns can be significant, here, too, the amount of cashchanging hands is smaller than with equivalent stock transactions.
Althoughoptions may not be appropriate for everyone, they're among the mostflexible of investment choices. Depending on the contract, options canprotect or enhance the portfolios of many different kinds of investorsin rising, falling, and neutral markets.
REDUCING YOUR RISK
Formany investors, options are useful as tools of risk management, actingas insurance policies against a drop in stock prices. For example, ifan investor is concerned that the price of his shares in LMNCorporation is about to drop, he can purchase puts that give him theright to sell his stock at the strike price, no matter how low themarket price drops before expiration.
At the cost of the option'spremium, the investor has insured himself against losses below thestrike price. This type of option practice is also known ashedging. While hedging with options may help you manage risk, it'simportant to remember that all investments carry some risk, and returnsare never guaranteed.
Investors who use options to manage risk look forways to limit potential loss. They may choose to purchase options,since loss is limited to the price paid for the premium. In return,they gain the right to buy or sell the underlying security at anacceptable price for them.
They can also profit from a rise inthe value of the option's premium, if they choose to sell it back tothe market rather than exercise it. Since writers of options aresometimes forced into buying or selling stock at an unfavorable price,the risk associated with certain short positions may be higher.
Manyoptions strategies are designed to minimize risk by hedging existingportfolios. While options can act as safety nets, they're not riskfree. Since transactions usually open and close in the short term,gains can be realized very quickly.
This means that losses can mountquickly as well. It's important to understand all the risks associatedwith holding, writing, and trading options before you include them inyour investment portfolio.
RISKING YOUR PRINCIPAL
Likeother securities - including stocks, bonds, and mutual funds - optionscarry no guarantees, and you must be aware that it's possible to loseall of the principal you invest, and sometimes more. As an optionsholder, you risk the entire amount of the premium you pay. But as anoptions writer, you take on a much higher level of risk.
Forexample, if you write an uncovered call, you face unlimited potentialloss, since there is no cap on how high a stock price can rise.However, since initial options investments usually requires lesscapital than equivalent stock positions, your potential cash losses asan options investor are usually smaller than if you'd bought theunderlying stock or sold the stock short.
The exception to this generalrule occurs when you use options to provide leverage: Percentagereturns are often high, but it's important to remember that percentagelosses can be high as well.
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