Buckle-Up! Why Your Stocks Need The Safety of Options

Buckle-Up! Why Your Stocks Need The Safety of Options

When I tell people that I trade options, I often get the same response: options are risky. Frankly, options are the opposite of risky – when they are used properly – they give traders the ability to limit risk and also increase their odds of winning. You wouldn’t drive your car without a seat-belt, why trade stocks without options? I’m going to show you how trading options can be more safe than just trading stocks.

Trading Stocks is Risky – Trading Options is Not

When you buy a stock, you have the potential to lose the entire investment. That assumes, of course, that the stock goes to zero – bankrupt. You don’t have to look back too far to see examples of that. Recall the financial crisis of 2007 and 2008. Lehman Brothers, Washington Mutual, and Countrywide once considered solid companies no longer exist. Don’t forget others like Chrysler and General Motors. Or Borders, Circuit City, Sharper Image, and Tweeter. They all went bankrupt.

And, it’s going on today. Pacific Sunwear (PSUN) recently and Alpha Natural Resources (formerly ANR now ANRZQ) recently filed for bankruptcy. Serval other companies are on the brink.

And here’s a few other companies which haven’t gone bankrupt (yet) but they have had epic falls in the past year:

1-Year High Recent Low
Valeant (VRX) $263.81 $25.20
Peabody Energy (BTU) $84.00 $2.00
LinkedIn (LNKD) $266.53 $98.25
Chesapeake Energy (CHK) $16.98 $1.50
Sears Holding (SHLD) $44.72 $14.05
GoPro (GPRO) $65.49 $9.01

I can recall hearing so called “experts” espousing each of those equities as good investments not too long ago. Think: Bill Ackman and Valeant.

The fact is that most people who pick stocks are wrong

That also includes the so-called “experts.” Take a browse of CXOAdvisory.com’s Guru List. There, you will find the performance record of many very well-known stock pickers. Most of the people on this list – two-thirds of them in fact– could not beat the flip of a coin when picking a stock. You would be better off doing the opposite of what most of them say.

In my experience, a lot of those people are not any smarter than you. The qualifications that give them the opportunity to provide recommendations in the media has more to do with how entertaining they are, rather than their track-record.

Low Beta is Not Low Risk

A personal pet-peeve of mine is beta. Nearly every week, you hear those experts telling you to pick “low beta stocks” to avoid risk. That is complete B.S. Consider the beta of those stocks mentioned above.

Valeant (VRX) 0.24
Peabody Energy (BTU) 0.93
LinkedIn (LNKD) 1.61
Chesapeake Energy (CHK) 1.77
Sears Holding (SHLD) 2.23
GoPro (GPRO) 0.66

Some of those qualify as “low beta” stocks. But, they are certainly not low risk!

If you think low beta means low risk, you don’t understand beta. And if someone advises you to trade “low beta” stocks, they probably are not qualified to give you advice. You can read more about beta here: Beta, Volatility, and Risk – What you need to know about Beta

Even if you do understand beta, it’s still hard to pick stocks.

Almost is Good Enough… for Options Traders

Educated and experienced option traders understand that with options, you can build trades to speculate, protect assets, or generate and income – or a combination of those.

A common example is the covered call. This involves buying the stock and selling a call. A long call is essentially a guarantee that the option buyer can buy the stock at an agreed price. The call seller is obliged to sell the stock at that price, if the option buyer exercises their right to buy.

Consider this example. Tesla (TSLA) is trading for $250.00 per share. A stock trader could buy that stock and has about a 50%/50% of making a profit. A covered call trader could buy the stock and also sell the June expiration call at the $250 strike for $19.35. The cost basis for that covered call trade is $230.65. (In options trading we trade in lots of 100 shares. The cost for the stock trade is $25,000 and the covered call is $23,065.) To make money on the stock trade, TSLA needs to be above $250. For the covered call, it’s got to be above $230.65. Which has more likelihood of making money? The covered call. The stock can fall by nearly $20 and the covered call can still be profitable. The probability of the covered call being profitable is about 57%.

Just like horseshoes and hand-grenades, almost is good enough for some options trades.

Trading Options Can Dramatically Lower Your Risk

What about the risk? The covered call risk is $230.65 and the stock trade risk is $250.00. Stock is slightly riskier.

What’s the drawback of the covered call over long stock? It is that the profit of long stock is theoretically unlimited, while the covered call trader is obliged to sell at $250 if the long call owner exercises the option. The maximum profit on the covered call is $19.35.

Is that good? That’s 8.4% in just 67 days or less. On an annualized basis that is 47%. I think that’s pretty good.

But what about the downside? TSLA has earnings on May 4. And TSLA has been known to have a massive pop or drop on earnings.

The options trader could decide to control their risk even more by buying a long put. The long put gives the owner the right to sell their stock at the specified strike price. Think of it as an insurance policy for your stock.

The combination of long stock, a short call, and a long put is a collar trade.

Let’s take a quick look at a collar trade on TSLA. If the covered call trader added the May $235 long put for $12.40, that would bring the cost basis of the trade to $243.05, where the maximum loss would be $8.05 and the maximum profit would be $6.95. The maximum return on risk is 116%. In actual dollars that would mean that while you invested $24,305 in the trade, you are only risking $805.

This is a simple example of how a trader could increase the probability of profit and also reduce risk.

But It Can Be Risky – If You Don’t Know What You’re Doing

I draw a parallel to driving a car. You are moving two tons of steel and glass, where explosions of flammable liquid propel you at speeds faster than a cheetah. We pass within just a few feet of concrete abutments; other vehicles; and even pedestrians. The consequences of a few simple mistakes could be catastrophic, yet we are all very comfortable driving cars. This is because we have rules, wear our seat belts, and were all trained how to operate a car safely. It is the same as options trading.

I recall a recent story in a financial publication about the dangers of options trading for retail traders. One example they cite is of a retiree who placed a covered call and had a huge loss. It wasn’t a covered call that caused the loss. In fact, the covered call lost less than if he had just had stock alone. And, if he had a collar trade in place, it would not have been news because his loss would have been far less significant! The story here is that the guy didn’t know how to use options. And no one seems to take notice when a stock trader takes a huge loss. That’s not news.

We don’t stop driving cars because there are accidents. But we do drive safer.

Options can provide the tools for traders to protect assets, speculate and profit from big moves, and generate income. But, like driving a car, safety and knowledge are essential.

Eric Hale
OptionsANIMAL Instructor

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Eric Hale

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