Transactions generally require less capital than equivalent stock transactions, and therefore return smaller dollar figures – but a potentially greater percentage of the investment – than equivalent stock transactions.
Even those investors who use options in speculative strategies, such as writing uncovered calls, don’t usually realize dramatic returns. The potential profit is limited to the premium received for the contract, and the potential loss is often unlimited. While leverage means the percentage returns can be significant, here, too, the amount of cash changing hands is smaller than with equivalent stock transactions.
Although options may not be appropriate for everyone, they’re among the most flexible of investment choices. Depending on the contract, options can protect or enhance the portfolios of many different kinds of investors in rising, falling, and neutral markets.
Reducing Your Risk
For many investors, options are useful as tools of risk management, acting as insurance policies against a drop in stock prices. For example, if an investor is concerned that the price of his shares in LMN Corporation is about to drop, he can purchase puts that give him the right to sell his stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option’s premium, the investor has insured himself against losses below the strike price. This type of option practice is also known as hedging. While hedging with options may help you manage risk, it’s important to remember that all investments carry some risk, and returns are never guaranteed.
Investors who use options to manage risk look for ways to limit potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price for them. They can also profit from a rise in the value of the option’s premium, if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.
Many options strategies are designed to minimize risk by hedging existing portfolios. While options can act as safety nets, they’re not risk free. Since transactions usually open and close in the short term, gains can be realized very quickly. This means that losses can mount quickly as well. It’s important to understand all the risks associated with holding, writing, and trading options before you include them in your investment portfolio.
Risking Your Principal
Like other securities — including stocks, bonds, and mutual funds — options carry no guarantees, and you must be aware that it’s possible to lose all of the principal you invest, and sometimes more. As an options holder, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise. However, since initial options investments usually requires less capital than equivalent stock positions, your potential cash losses as an options investor are usually smaller than if you’d bought the underlying stock or sold the stock short.
The exception to this general rule occurs when you use options to provide leverage: Percentage returns are often high, but it’s important to remember that percentage losses can be high as well.