02 May 2008

A Quick Word On Risk

Out there in options land there are various, and sometimes-conflicting statements on the risk involved in options trading. They limit risk, they’re very risky, naked options have unlimited risk, etc. etc. etc.

I want to take this opportunity to dispel any notions you may have about risk in options trading. I’m jumping ahead just a little bit, but now is a good time to get this particular point across. Once again, if you’re a beginner some of the terminology might be foreign, but don’t worry about that right now. As you go through the course, you’ll hark back to this section and it will begin to take on more and more significance; trust me on that.

In any market where options exist on an underlying instrument, whether that is common stock, a futures contract or anything else, there are six possible single leg positions.

1. Long stock
2. Short stock
3. Long call
4. Long put
5. Short call
6. Short put

Let’s say we have the common stock XYZ trading at $50 per share with the ATM options trading at $2.50 apiece (both puts and calls to make it easy) and six traders who each take on one of the above positions.

Important: The presumption is that all the option trades are the same strike price and same expiry.

1. The first buys 100 shares @ $50.
2. The second 2 shorts sells 100 shares @ $50.
3. The third trader buys one $50 call contract (representing 100 shares) @ $2.50.
4. The fourth trader buys 1 $50 put contract @ $2.50.
5. The fifth trader writes (short sells) 1 $50 call contract @ $2.50.
6. The sixth trader writes 1 $50 put contract @ $2.50.

What happens to the profit or loss of each of these traders if the stock is trading at $40 at the option expiry? I won’t go into the mathematics or the mechanics right now, because we’ll be going into that in depth in the course, so you’ll have to trust me on the figures. Brokerage and spread will make a small difference, but for the sake of simplicity we’ll ignore that right now.

1. The trader who bought loses $1,000.
2. The trader who short sold makes $1,000.
3. The trader who bought the call loses $250.
4. The trader who bought the put makes $750.
5. The trader who wrote the call makes $250.
6. The trader who wrote the put loses $750.

There is a lot of analysis that can be gleaned from the above, but what want you to notice in this instance, is the risk of each position. It turns out that the long stockholder has lost the most money. So does that mean that common stock is the most risky? Note also the stock short seller made the most money.

Now I want you to add up all the profits and losses above. Notice it comes to zero.

Again, lets look at what happens if at option expiry the common is trading at $51.00:

1. The trader who bought stock makes $100.
2. The trader who short sold stock loses $100.
3. The trader who bought the call loses $150.
4. The trader who bought the put loses $250.
5. The trader who wrote the call makes $150.
6. The trader who wrote the put makes $250.

In the above example it is the long put trader who has lost the most money, in fact both the long put trader and the long call trader have lost more than the trader who shorted stock, but both the option writers made more than the long stock trader. Does this mean that long options are the most risky position?

Note once again the results all add up to zero.

What I’m hoping you see from this little exercise is that options are not more or less risky than common stock, but that options “transfer” risk. This is apparent in the way that all the sum of all the above position’s profit and loss result in zero. I hope you see that the assertions that you hear about unlimited risk in naked options and that long options reduce risk is largely nonsense.

In fact the person that gravely cautions you about the risk in naked puts, yet will quite happily go long the common, is cognitively dissonant. We’ve shown that in the first scenario, where the long stockholder carries the most downside risk.

Likewise, the person who will indiscriminately buy options to “limit his or her risk” is due a few shocks.

With options, it is not less or more risk that the trader accepts, but they do alter their risk profile. The fantastic thing about options is that you get to select exactly where you want your risk to be and exactly where you don’t want your risk to be.

Now I don’t want to play down the fact that you can lose money trading options. The fact is that you can leverage yourself to ludicrous proportions, and many option traders do just that

This is the really important thing to learn about options trading; understanding exactly where your risks are, how big they are, the face value of your position, what you’ve accepted in order to achieve the particular goal you had in mind, and being aware of how your position may hurt you.

Next - What Are Options

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