Options Trading and
Risk Management

Options Trading and Risk Management

There are more kinds of risk than there are investments, since every instrument carries several kinds. But risk isn't inherently bad. Without it there'd be fewer opportunities for profit.

The fundamental risk, of course, is price uncertainty. No one knows for sure whether GOOG (the symbol for Google stock) will be higher tomorrow or lower.

Options, like futures or bonds, carry an additional risk - at some point, from a day to several months or years, they expire. On or before that date, the holder has to decide whether to sell the contract, exercise the option to buy or sell the underlying asset, or simply let the option expire.

Each of these choices carries implications for gain or loss and all are uncertain (to some degree) with respect to the size of that outcome.

Complicating the price and timing risks of options is their volatility risk. It's 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, say a stock or bond, has risks as an investment buying options allows holders to compensate for them.

Leverage is one form in which options help to 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 $40,000 (excluding commission). That's a hefty sum for the average investor.

But you can control 100 shares of GOOG without owning them for less than 1/10th the cost - currently around $2800 - 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 $40,000 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. 3Com and Cisco are two good examples. Though not zero, their shares experienced considerable declines in the past few years.)

Purchase one option instead and your principal risk is limited to the - painful if lost, but much smaller - amount of the premium: $2800, the cost of the options. (Excluding commissions.)

Of course, the example is a little unfair since the odds of Google stock going to zero is itself close to zero. But there are companies for whom the odds are not so favorable and the principle (pun intended) is the same.

So, how do you manage these risks? Simple. Simple, but not easy.

Start by identifying all the known risk factors and quantifying them. (Simple in that identifying and measuring them is straightforward, but minimizing them is anything but easy.)

Fortunately, there are several different software product offerings that will help you do that. It's no longer necessary to be a finance and mathematics wizard. The software incorporates the algorithms used by experts to measure various factors - such as delta, theta, vega, volatility and others - that can affect your potential profit or loss.

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