Reducing Risk With Options

Many people mistakenly believe that options are riskier investments than stocks. This stems from the fact that most investors do not fully understand the concept of leverage. However, if used properly, options can have less risk than an equivalent position in a stock. Read on to learn how to calculate the potential risk of stock and options positions and discover how options - and the power of leverage - can work in your favor.


What Is Leverage?
For the record, leverage has two basic definitions applicable to option trading. The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into trouble. A dollar amount invested in a stock and the same dollar amount invested in an option do not equate to the same risk.
The second definition characterizes leverage as maintaining the same sized position, but spending less money doing so. This is the definition of leverage that a consistently successful trader incorporates into his or her frame of reference. This is the definition that investors must now understand and embrace.

Playing the Numbers
You may believe that if you are going to invest $10,000 in a $50 stock, you would be much better off investing that $10,000 in $10 options. After all, investing $10,000 in a $10 option would allow you to buy 10 contracts and control 1,000 shares.

Meanwhile, $10,000 in a $50 stock would only get you 200 shares. It is easy to see the obvious disparity here and our greed always is seeking a higher potential for profit. Unfortunately, most investors can't see past that. The problem is that there is another disparity here beyond the obvious difference in the numbers of shares an investor can control. This disparity is not so easily seen by investors blinded by greed: risk. (For more insight, see Trading A Stock Vs. Stock Options - Part 1 and Part 2.)

In the example above, the option trade has much more compared to the stock trade. With the stock trade, your entire investment can be lost, but only with an improbable movement in the stock. In order to lose your entire investment, the $50 stock would have to trade down to $0.

In the option trade, however, you stand to lose your entire investment if the stock simply trades down to the long option's strike price. For example, if you own the 40 strike (an in-the-money option), the stock only will need to trade below 40 by expiration for the entire investment to be lost. That represents only a 20% downward move.

Clearly, there is a large risk disparity between owning the same dollar amount of stocks or options. This risk disparity exists because the proper definition of leverage was applied incorrectly to the situation. To correct this problem, let's go over two alternative ways to balance risk disparity while keeping the positions equally profitable.

Conventional Risk Calculation
The first method you can use to balance risk disparity is the standard, tried and true textbook way. Let's go back to our stock trade to examine how this works:

If you were going to invest $10,000 in a $50 stock, you would receive 200 shares. Instead of purchasing the 200 shares, you could also buy two call option contracts. This is because one contract is worth one hundred shares of stock. Therefore, two contracts would be worth two hundred shares of stock. By purchasing the options, you can spend less money but still control the same number of shares. The number of options is determined by the number of shares that could have been bought with your investment capital.

For example, let's suppose that you decide to buy 1,000 shares of eBay at $41.75 per share for a cost of $41,750. However, instead of purchasing the stock at $41.75, you could also buy 10 of the January 2008 (in-the-money) 30 strike calls for $1,630 per contract. This option has an 86 delta, which means that it will mimic the performance of the stock to 86%. If the stock trades up a dollar, the option will increase in value by eighty-six cents. The option purchase will provide a total capital outlay of $16,300 for the 10 calls. This represents a total savings of $25,450, or about a 60% of what you could have invested in eBay stock.

Being Opportunistic
This $25,450 savings can be used in several ways. First, it can be used to take advantage of other opportunities, providing you with greater diversification. Another interesting concept is that this extra savings can just sit in your trading account and earn money market rates. The collection of the interest from the cost savings can create what is known as a synthetic dividend. During the course of the life of the option, the $25,450 savings will gain 3% interest annually in a money market account. That represents $763 in interest for the year, equivalent to about $63 a month or about $190 per quarter. Divide the $190 per quarter by the 1,000 eBay shares that you control and you have created the equivalent of a $0.19 quarterly dividend. (For related reading, see The Importance Of Diversification and The Power Of Dividend Growth.)

You are now, in a sense, collecting a dividend on a stock that does not pay one while still seeing a very similar performance (86%) from your option position in relation to the stock's movement. Best of all, this can all be accomplished using less than one-third of the funds you would have used had you purchased the stock.

Alternative Risk Calculation
The other alternative for balancing cost and size disparity is based on risk. We'll refer to this as "Ron's risk calculation."

As you've learned, buying $10,000 in stock is not the same as buying $10,000 in options in terms of overall risk. In fact, the money invested in the options was at a much greater risk due to the potential of a greater loss, even when controlling a smaller number of shares. In order to level the playing field, therefore, you must equalize the risk and determine how to have a risk-equivalent option position in relation to the stock position.

Positioning your Stock
Let's start with your stock position: buying 1,000 shares of a $41.75 stock for a total investment of $41,750. Being the risk-conscious investor that you are, let's suppose that you also enter a stop-loss order, a prudent strategy that is advised by most market experts.

You set your stop order at a price that will limit your loss to 20% of your investment, which is $8,350 of your total investment of $41,750. Assuming that this is the amount that you are willing to lose on the position, this should also be the amount you are willing to spend on an option position. In other words, you should only spend $8,350 buying options. That way, you only have the same dollar amount at risk in the option position as you were willing to lose in your stock position. This strategy equalizes the risk between the two potential investments.

If you own stock, stop orders will not protect you from gap openings. The difference with the option position is that once the stock opens below the strike that you own, you will have already lost all that you could lose of your investment, which is the total amount of money you spent purchasing the calls. However, if you own the stock, you can suffer much greater losses. In this case, if a large decline occurs, the option position becomes less risky than the stock position.

For example, if you purchase a pharmaceutical stock for $60 and it gap-opens down at $20 when the company's drug, which is in Phase III clinical trials, kills four test patients, your stop order will be executed at $20. This will lock in your loss at a hefty $40. Clearly, your stop order doesn't afford much protection in this case.

Other Options
However, let's say that instead of purchasing the stock, you buy the three-month out $50 calls for $11.50. Now your risk scenario changes dramatically - when you buy an option, you are only risking the amount of money that you paid for the option. Therefore, if the stock opens at $20, all of your friends who bought the stock will be out $40, while you will only have lost $11.50. When used in this way, options are actually less risky than stocks.

Getting back to our eBay example, we will now make our option purchase using the appropriate amount of funds as determined by Ron's Risk Calculation. Keep in mind that the choice of the correct option (month and strike) is also essential to this strategy. For now, we'll look for an in-the-money option with a delta of around 80-85. Let's assume that you believe that the eBay movement will be over in the next couple of months and you want to choose an expiration month that matches the time frame you anticipate the movement will take.

For this example, let's choose the eBay April 37.5 calls with an 82 delta, which is trading at a price of $5.20. Remember, the stock is trading at 41.75 and, therefore, the option is in-the-money. Using Ron's Risk Calculation, you've determined that you can spend up to $8,350, or the amount of money you were willing to lose on a stock purchase as determined by your own stop-loss limit. This will allow you to purchase 16 contracts (at a price of $5.20 per share, each contract would be $520). If you divide the total amount ($8,350) by the amount it costs to purchase one contract ($520), you will get 16.057692 as an answer. This means that you can buy 16 contracts for a total expense of $8,320.

When you compare your stock position and your option position, you will find that you have an equal amount of total dollar risk in both positions; however, your option position will cost you much less in terms of capital outlay - you will control 1,600 shares instead of only 1,000 (a 60% increase). This will likely give you a better percentage return while guaranteeing a fixed limited loss under conditions when a stop order on a stock offers limited protection.

Conclusion
Whether using a conventional risk calculation or Ron's Risk Calculation, determining the appropriate amount of money that you should invest in an option will allow you to use the power of leverage that options can provide while keeping a balance in the total risk of the option position over a corresponding stock position.