The Supreme Myth of the Risk of Options Debunked
The Supreme Myth of the Risk of Options Debunked
I was recently talking to a very well educated corporate lawyer who is the father of my daughter’s basketball teammate and the conversation turned to investments. I told him what I did and that my passion was options. The reaction “Oh My, Options they are too risky for me.” I cringed and said “No!! No!! Let me tell you the facts.”
Options are of one of the most innovative and important investing instruments that have ever been created by the investment community, but options are also widely misperceived and misunderstood by the public at large. There is this unfounded myth held by some that options are risky derivative instruments that are to be avoided at all costs. Derivatives has become a pejorative word these days since the housing bust and 2008 banking crisis and equity and index options have been unfairly tarnished by the broad brush of the derivative stigma. Derivative simply means derived from. Yes, options are derived from an underlying instrument, an equity, index, commodity or other instrument but they are not inherently more risky than owning that underlying instrument. Options if used correctly can actually be a risk reducer.
The most educated among us misunderstand the risk nature of options. The beauty of the options is its tremendous flexibility. You can trade directional or non-directional. You can set your time frame. You can set your risk/reward and probability of success based on your personal risk tolerance.
Why the bad rep?
Let’s first examine why options have been viewed by many as a risky investment vehicle.
1) Media hyperventilation and misuse of the term ‘derivatives’. The stock market meltdown in 2008-2009 was primarily caused by derivative products tied to sub-prime mortgages and had nothing to do with standard listed derivative products like equity options. Equity Options however were painted with the broad brush of derivatives and the myth of options as risky instruments grew.
2) Leverage- Another dirty word for much of the retail investing public.
Most retail customers still primarily trade equities and those who trade options most likely at one time learned to trade with equities. The risk/reward of trading stocks is easy to understand; if you buy a stock you will make or lose money according to the amount of shares go up or down. If you have a margin account and buy the stock with margin, this effect will be doubled. You must pay interest on the money borrowed and if you believe the investment is a good one, you will have to outperform the cost of money borrowed. The ability to manage the risks of the added leverage is paramount because increased leverage can cut both ways. Winning trades have outsized positive returns, however if you are wrong, you are equally penalized.
Here is the kicker with options:
Standardized options basically represent 100 shares of the underlying stock. In essence, you have increased your leverage. An increase in leverage with not the prerequisite skills to manage the increased leverage can create nasty surprises in an investment portfolio. This is where the aspect of leverage hurts the reputation of options, fairly or not.
The debunking in a nutshell:
Risk reducer- if you are long the underlying, you can reduce risk by either:
- Straight buying puts or:
- by putting on a trade called a Collar, which is long underlying and selling out of the money calls and buying puts. This is a basically a covered call coupled with long puts for protection.
A 2009 white paper released by the Options Industry Council shows the results of a 10-year study by researchers at the University of Massachusetts. The study found that a long protective collar strategy using six-month put purchases and consecutive one-month call writes earned superior returns to a simple buy-and-hold strategy and reduced risk by almost 65 percent. The collar strategy allows you to participate in the upside, to a certain extent, and effectively reduces downside risk.
It has been said that it is better to have insurance before your house burns down rather than try to buy it as it's burning down. This can also be said when talking about purchasing insurance or put options to hedge an equity portfolio.
Is your house burning?
We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .
Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.
Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.
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