In the Money: Options and Risk, Part I

I've spoken to many people about the risk of using options as part of an investment strategy. Are options risky? Are they riskier investments than investing in stocks or mutual funds? The answer to both of these questions is, it depends on how options are used. When used properly, options can significantly reduce your risk and provide you with enhanced control over your investments. And like their name, they provide investors with more options to spread risk and profit from the market. They are another set of tools employed by corporations and sophisticated investors across the world.

Options go as far back as Roman times when they were used to purchase flour and wheat. In modern times, corporations across the world use options to hedge against oscillations in energy, currency, and commodity prices. In fact, it is the Risk Control group in corporate finance departments that utilize options. Options are widely traded, a testament to their usefulness and the Chicago Board Options Exchange was the pioneer and is today the largest options exchange in the world.

But to really understand how options can be used to minimize risk, I have prepared a real world example. Suppose I have $11,025 (we're using this number to make the example work) that I want to invest. I have been eyeing General Electric for awhile and believe that it may be the time to buy. The companies stock has dropped from a 52 week high of 53.55 to 35. I like GE, think it's a good company, and believe that the stock will rebound. But I am a little bit nervous because of some issues which have been swirling around. I sense upside potential but, like any stock investment, there is risk.

I have several options at this point.

1. I can buy 315 shares of the stock ($11,055/35) outright and hope that the stock goes up.

2. Or, I can purchase 300 shares of the stock and use the remaining money to buy 3 Put contracts. These contracts protect me so that if the stock goes up I still profit but if it goes down, I minimize my losses.

Let's look at each of these scenarios in more detail.

Purchase the Stock Outright

 

I decide that I want to purchase the stock outright and purchase the 315 shares of GE.

The price drops or rises by 315 points (the number of shares you own *1) for every point that the stock goes up or down. Thus if the stock dropped by 20 points, you would lose 285* 20 = $6,300. If the stock drops to 0, you would lose all $11,055.

Purchase the Stock and a Put Option

 

Now, let's look and see what happens if we buy the stock and an option to try and minimize our risk. We still have $11,055 that we want to invest. With this $11,055 we are going to purchase 300 shares of GE stock for $10,500 and we are also going to purchase 3 March 35 Put option contracts for $185 per contract or $555 total.

What does Put March 35 mean? Let's decompose:

A put is a contract that gives the buyer the right, but not the obligation to sell a stock at the strike price anytime before expiration.

March is the date when the option expires.Â

35 is the strike price. You have purchased the right, but not the obligation to sell your stock at a price of 35 anytime before the option expires (in March).

Each Option contract covers 100 shares so we are purchasing 3 contracts to cover the 300 shares we bought outright.

This may seem confusing to investors who do not have options experience. To put it another way, by purchasing these options, you are gaining the right to sell your 300 shares of GE to someone before the contract expires in March even if the stock drops to 0. Someone else has the obligation of buying this stock from you at 35.

Note that what the option does it limit your downside risk. The maximum you can lose, even if the stock goes to 0 is $555. Now imagine if the employees of Enron had been savvy enough to purchase Put options. Because they were prevented from withdrawing money from their pension plan, they could have hedged their position with Put Options and minimized the loss to their retirement savings. Not understanding how to use options cost many of these employees their entire retirement plan.

Purchasing a Put Option though does reduce your upside. That is because Options do not come free. Options cost money, just like insurance. Even if you don't need it, you have still payed a premium for their protection (In this case $555 for the 3 contracts). It is up to the individual investor to decide if this premium is worth it.

If you didn't understand the intricacies of this example, hopefully you understood the main point that Options are not inherently risky financial instruments. They have many benefits and can be used to more tightly control risk and reduce total exposure. They are part of the arsenal of most sophisticated investors, from pension plans, to corporations, to individual investors and should not be immediately dismissed. In future articles, we will continue to provide you with the fundamentals to understand the strengths and advantages of making options a component of your investment strategy

For more information on Put options, please check out the educational tutorial at the Chicago Board Options Exchange at:

http://www.cboe.com/LearnCenter/cboeeducation/Course_01_01/mod_01_01.html