How to Manage Risk Using Options
The consensus on options trading is that it is risky for the average investor. You’ll likely hear stories about people losing large sums of money in the options market.
This sentiment about options being risky can be warranted. However, it often comes from a lack of understanding about how the options markets work.
This article will help you learn instead how to actually manage risk — using options.
Compare the purchase of a stock at $50 per share vs. buying a six-month call options contract on that same stock.
Both transactions are for 100 shares. Further, suppose the premium on the options contract is $2.75 (x 100, which is $275).
A $10 drop in the stock price represents a paper loss of $500 for the stock trade. However, no matter how far the stock drops, the risk for the options trade is always the same, $275.
Buyers of options never lose more than the premium paid.
If the stock is sold anytime after the drop in price, the stockholder faces a realized loss. Any loss greater than $275 would indicate that the risk of holding the stock is greater than the risk of holding the option.
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