Why Understanding Risk Can Lead to Lucrative Trades

It’s crazy…

I’ve seen smart, seemingly sensible folks bet their entire savings on a single stock.

And they seem totally surprised when they blow up their account.

Yet ask them if they’ve considered trading options, and they’ll tell you, “No way! Options are simply too risky.”

It doesn’t make any sense…

Of course, with options you always need to understand any risks you’re taking on. But you don’t want to miss out just because you misunderstand them.

To better explain those risks, today I want to compare buying stocks to an options strategy…

Risks and Obligations

Take, for example, someone who buys 100 shares of a stock at $50.

They know exactly how much risk they’re taking on. (That’s simple math: 100 shares × $50 = $5,000.)

Of course, if they’re confident in the stock they’re buying, they’ll likely think that their risk is much less.

But any stock can go to zero.

Now compare that to options. Say you sell one put option instead…

By selling a put, you’re willing to buy 100 shares in the underlying stock if the buyer exercises the option.

For taking on that risk, you receive a premium from the buyer. It’s like how an insurance company receives a premium for insuring your car or home.

The main thing is that if the buyer exercises that option, then you must buy 100 shares at the agreed-upon price.

So if you agreed you’d buy 100 shares for $50, but the stock is trading at $30… you’ve still got to fork out $50 a share.

That’s why some folks think options are so risky.

(And often, they sell more option contracts than they should. Even though they’d only be willing to buy 100 shares outright, they decide to sell five options contracts. So now they’re on the hook for 500 shares at an unfortunate price.)

Ultimately, people who treat options like this don’t really understand risk.

Because if you do, you can see how trading options can help you, not hurt you.

Whether you buy shares outright or sell a put option, the stock price can go down.

But let’s say we sell one put option with a $50 strike price and receive a $5 premium. (A $5 premium × 100 shares per contract = $500.)

Our breakeven stock price is now $45. So the stock could fall from $50 to $45, and we would still be OK.

Compare that to the $50 breakeven price of just buying the shares outright.

Don’t Miss Out on the Rally

With the above example, a different problem can arise if our put option doesn’t get exercised…

We get to keep the premium we earned by selling our option. But we miss out if the stock rallies.

By comparison, a stock buyer takes part in any rally.

So how can we benefit in a similar way using options?

This is where a second option leg can come into the picture.

By also buying a call option, you gain access to the upside if the stock rallies.

So to recap…

If the buyer exercises our put option, we buy 100 shares at a lower cost than if we bought the shares outright (because of the premium we earned).

And our call option allows us to benefit from any rally.

The beauty is that the premium we receive for selling the put option should cover the cost of our bought call option.

This means we have similar exposure to someone who bought the stock… but we’re still in a better position because of the premium we earned from our put option.

While all this may seem complex, the important takeaway is this…

Trading options is all about understanding and managing risk…

And if you learn the ins and outs, you can use options to your benefit with some lucrative trades.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict