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Next week, on June 26, at 2 p.m. ET, I’m going to share one of my absolute favorite trading strategies… one that’s gotten even more exciting due to the unexpected turbulence from each of President Trump’s moves.
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I look forward to seeing you there!
One of the great perks of my job is that I get to teach people about options. I’ve been passionate about them for most of my 40-year trading career.
But one of the most common objections I receive is that folks tell me that options are risky.
Of course, trading options can be risky if you don’t fully understand what you’re doing.
That’s why I enjoy educating people about how they work. You don’t want to miss out on the benefits of trading options just because you don’t understand them.
In fact, a better understanding of options helps you better understand risk itself.
To see how, let’s run through an example…
Options as Insurance
Take, for example, someone who buys 100 shares of a stock trading at $100. The risk they’re taking on is $10,000.
Now, if they’re confident in their research, they might believe that their risk is less than that. But it’s a simple fact that any stock can go to zero.
So to protect themselves, they buy a put option with a $100 strike price. That gives them the right (but not the obligation) to offload those shares at $100 per share until the option’s expiration.
In effect, the put option acts as insurance. The investor is happy because they’re covered.
They’ll profit if the stock price rises. But if the stock price tanks, the put option protects them from the fall (until expiration).
This is a conservative strategy. Many folks might deem this as “safe” – especially in comparison to other “riskier” options.
But again, this is where understanding options gives you a better understanding of risk…
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The Same Risk & Reward
One of the great benefits of options is that they can be used to “replicate” other strategies. And you can often do so at just a fraction of the cost.
So let’s go back to our example…
The put option enables the investor to exit their position at the same price they bought the stock ($100). And they’ll profit from a rally in the stock price.
Well, that’s the same risk/reward profile as buying a call option.
Just like buying shares, a call option will help you profit from a rally in the underlying stock. If the stock price rises from $100 to $110, for example, you could execute your option to buy 100 shares at $100 and then immediately turn around and sell those shares for $110. Or you could simply sell your option back to the market for a profit.
But if the stock price tanks, the most you lose is what you paid for the option. That applies even if the underlying stock plunges to zero.
In options jargon, we say that these two strategies are “synthetically equivalent.” That is, buying a call option has the same effect as buying shares and a put option.
The key thing is, you can buy that call option for a fraction of the cost of buying the underlying stock plus a put option.
Instead of locking up $10,000 (plus the cost of the put option), you’re likely locking up only a few hundred dollars per contract.
So you’re using less of your available capital to gain exposure to the same position.
To be clear, options have an expiration date. So you need to have conviction that the anticipated move is going to play out within that time frame.
But it’s important to appreciate what options offer you. They let you gain access to an up move for just a fraction of the cost of buying shares. All the while, they help reduce your risk.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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