Option Trading Strategy Part 2 - Profit and Risk
Risk isn't inherently bad. Without it, there would be far fewer opportunities for profit. In particular, there would be no options market at all. No one would have to speculate on price direction or other factors, since risk always implies uncertainty about the future.
But risks come in different flavors and degrees. Let's examine some trading strategies with an eye toward risk...
The simplest options trade, the one usually first executed by investors moving beyond stock or bond investing, is the long call. A call is a contract that confers the right to buy an underlying instrument at a set price, the strike price. For this right, the buyer pays a 'premium' - the cost of the option.
When that strike price is below the current market price, the option is said to be 'in the money', when above it's 'out of the money'. But whatever the market price when the option is purchased, the buyer is speculating that the market price will be above his cost (strike price + premium + commission) before the option expires.
The amount by which the market price is above that cost determines the amount of profit. Since, in theory, the market price can rise indefinitely, the profit potential is called 'uncapped'.
Unlimited potential profit, but not without risk. As the famous banker J.P. Morgan said when asked what the stock market would do: 'Prices will rise, and prices will fall.' When the price falls below, or fails to rise above the cost of the option the investor loses money. In this case, however, the risk is obviously limited to the amount of the option (plus a small commission).
These kinds of options make for wise investments for those with limited experience but who want to take advantage of the additional leverage provided by options. Leverage is the ability to control more than you own. Since the option price is typically around 5% of that of the underlying stock, the leverage is 20:1. This multiplier effect is one thing that makes options so attractive.
Be sure the option has adequate liquidity, though. Open interest (the total outstanding contracts) should be no less than 100. The higher the better.
J.P. Morgan was right, prices sometimes fall. Sometimes they fall far and for a long time. When an investor judges this is likely, the next simplest options trading strategy can be employed: buying a put.
A put is a contract granting the right to sell an asset at a set price before or by expiration. It's slightly more difficult to understand, since the idea of selling something you don't own is odd.
Just like shorting stock, the trade (imagining the option were exercised) actually involves effectively borrowing the shares then immediately selling them. However, the investor never sees the underlying mechanics. As with shorting stock, the investor is on the hook for the 'borrowed' amount.
In this scenario the put buyer is speculating that the market price will fall below the strike price.
This is another situation in which the maximum risk is capped, this time by the price paid for the put. The reward too is capped, since the market price can't fall below zero. The maximum profit in that case is the strike price minus the cost of the put.
As with calls, ensure you choose an underlying instrument with adequate liquidity, preferably shares of over 500,000 ADV (Average Daily Volume). Look for open interest amounts over 100.
When trading options always be sure to select those with enough time left to judge the market trend. An option near expiration will be cheaper (options contracts are themselves actively traded), but carry higher risk. And risk is a bad thing... sometimes.