Lately we have a lot of talk about option strategies in stock2own community. I think I could find one more reason for myself to trade options. The reason is minimizing risk. And I’m not talking about total amount of money invested (options are cheaper than underlying securities); I’m talking about risk in general.
What is the best way to manage risk? Diversify. How can I diversify if my account has only few thousand dollars in it? I mean, how many securities can I invest in? Well for $5000 I can buy only 10 shares of Google or 12 shares of Apple. This is not a diversification.
At the same time, I can buy 1 contract (100 shares) of Google for about $500. And it will take only 10% of my account money. This is exactly what I want – do not invest more than 10-15% of my money into a single security.
I used to find myself in a position where I find a stock I like, I can see that all technical indicators suggest “buy” and I jump in. I paid 60-70% of my account to buy as many shares of this stock as I can. I had to do it simply because the size of my account is too small. And very often in a day or two I could find another stock with even better fundamentals and even stronger technical indicators. And … I had no money left to invest. Trading options should solve this problem. But, where is the catch?
The catch is when you buy a stock and you are right about price direction, you have a good chance to make money. Trading options you have to be right about underlying price moving direction AND time as well! As Mr. Natenberg put it in his book “Option Volatility & Pricing”:
If someone thinks the market is going up, he or she will tend to buy calls. And if it turns out these people are right, and market did go up, they might end up losing money. Why did they lose money? Buying calls is supposed to be a bullish position, and the market went up. But of course what was happening is the market was going up slowly, not sufficiently fast enough to offset the decay in the option.
So, using options you can reduce the risk by diversifying, but you have to be right in both market direction as well as timing. Nothing is free, I guess.
Tags: option stock market risk
