Options can be used to provide extra income, allow you to profit in every different market trend, and protect the money you already have. Options can be used to smooth out your returns, protect you in a down market and insure against the risk of catastrophic loss in your portfolio. With all these amazing abilities, why are options so often vilified as being unsafe and risky? The truth is that options can be very dangerous if used incorrectly. The problem is not necessarily with the options themselves, but with the trouble they allow you to get into if you don’t understand the nature of the risk.
To illustrate the problem, let’s compare two similar trades. The married put and the long call. At the time I write this, Disney (DIS) is trading for $92.45 per share. Disney has earnings on November 11. If I want to get into the stock, but worry about a possible large move to the downside, I can buy the stock and a December strike 90 put for 1.82. That strategy would increase my cost basis, but also limit my loss to the downside. It would also leave open the possibility of unlimited gains to the upside. If I buy 100 shares of stock and one contract of the puts, my total debit is the cost of the stock plus the cost of the put: $9,427. However, my risk is the total cost minus the strike of the put: in this case, $427. I have preserved my ability to participate with Disney if it rises, and greatly reduced my downside risk. So far, so good.
I could accomplish a very similar result by purchasing a long call in the same month and strike price. As I write this, the December strike 90 call costs $4.15. One contract would set me back $415 and that would be my total risk. As with the married put strategy, the call would also allow me to participate in the unlimited upside potential should Disney climb higher. At first glance, these appear to be nearly the same trade with very similar risk and reward.
The problem is not with the options, but with the way they are treated by the broker. This is easiest to see in a cash account like an IRA. In the married put version of the trade, the broker will hold the entire cost of the stock and option aside, and that money is unavailable for other trades. In other words, although the total risk to the portfolio is $425, $9427 will be unavailable for trading. The person with a $10,000 account would only be able to do one of these trades. However, with the long call version, the broker will only hold back the cost of the call. In the same $10,000 account, you could do 24 of these trades. This exposes the account to incredible risk as the chance of the long call losing all of its value is quite high. That may not be a problem when the loss is limited to $415, but it is a disaster for an account filled with these trades.
Most traders are wise enough not to fill their entire portfolios with long calls on a single stock. However, I have seen people endanger themselves by placing options trades on several different equities in the mistaken belief that they are protected by diversification. The problem is that when the entire market falls, all of the options trades, on all the different equities could be wiped out. The solution is not to avoid options and all the benefits they can provide. Instead, you must have a realistic view of the total risk in your portfolio as a whole, and not just the risk in each individual trade. Moreover, you need a good understanding, not only of the amount of risk but the probability of that risk materializing. It is very difficult to lose 100% percent of the money you invest in an equity. For that to happen, the company would have to go bankrupt. On the other hand, it is relatively easy to lose 100% percent of the money in a long call. Each different trade structure has its own probability of loss and must be assessed for the risk it contributes to your portfolio. In level 6 of our program, we teach portfolio management and ask students to think about these important issues. Once you understand how options work, their benefits and their risks, you will be much better able to use them to your advantage and avoid the pitfalls.