Are Stock Options Risky?

Are Stock Options Risky?

Warren Buffet ordinarily makes use of stock options to reduce risk in stock and to acquire stock at a reduced cost. If he is using stock options, they must be lower risk than just owning stock. You can already trade stock options in your IRA. That is the simple answer, but continue reading to learn why this is true.

On a dollar for dollar basis, stock option trading is less risky than stock trading over a given period of time. For example, if you thought Microsoft was going to increase in value over the two months after release of Vista, you could has either bought the stock for around $29.50 per proportion or bought a $30 strike price Jan ’07 call for $0.70 per proportion. Since a stock option covers 100 shares, the option cost is $70.00 to control 100 shares versus $2950.00 to own 100 shares. If the stock goes up to $30.00 per proportion the option will be at about $0.92. You can calculate this using a stock option pricing calculator. That small movement in the stock results in a 30% return on the stock option and a 1.7% return on the stock. This is called leverage and is a hallmark of stock options trading. On the third Friday in Jan ’07, Microsoft was up to $31.11 per proportion. Using your call, you can buy the stock at $30.00 or you can just sell your call for $1.11 per proportion, generating a 58% return on the stock option.

What if Microsoft drops? If it drops by $5.00 to $24.50, you have lost $5.00 per proportion on the stock but the most you loose on call stock option is the amount you paid or $0.70 per proportion. That is much less risk than owning stock if you are wrong and the stock goes down.

When you are long (buy) a stock option your risk is always limited to how much you paid and is always much less risk than owning the stock. The high risk in stock option trading occurs when you short (sell) options and you do not own the stock for a call option you sell or have the cash for a put option you sell. There is no need to do this.

Did you know you could already eliminate the need to forecast whether a stock is going to move up or down? You can use direction neutral stock option trading, such as straddle trading, to generate income if the stock moves either up or down. The risk in these trades is limited to your initial cost. Sometimes you can already setup some direction neutral stock option trades at no cost.

Stock options can also be used to reduce your risk in stock ownership. If you own a stock that is not moving, something that most stocks do about 80% of the time, you can sell a call option against it at a strike price higher than your stock cost. For example, assume you paid $25 per proportion for stock and sell a $27.50 strike call option for $0.50 per proportion. If the stock goes to $27.50 at expiration of the option, you have to sell the stock at $27.50. You would make total of $3.00 per proportion ($2.50 on stock and $0.50 on option). If the stock goes down or does not move above $27.50 by expiration, you get to keep the stock and the amount you were paid when you sold the call option. That is like generating your own $0.50 per proportion dividend. Also it reduces your cost in the stock by $0.50 per proportion. consequently the most you can lose on that stock is 24.50, not the original $25.00.

So to answer the question, stock option trading done correctly is much less risk than stock trading. Stock options allow you to diversify much better with same amount of capital. The risk in stock option trading that is not present with stock trading is their limited lifetime. Stock options do expire. This method your forecast for the stock movement has to happen within the time frame of the options you use. This can range from 1 day to almost 3 years.

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