Stocks Riskier Than Options Trading?

| December 6, 2011 | 0 Comments

Trading Stocks Can Be Riskier Than Trading Options

There are many significant risks unique to holders and writers of options. For example, an option holder can lose their entire investment in an option if they allow it to expire worthless. The writer of naked call options risks potentially unlimited losses should the price of the underlying security rise above the option’s exercise price. These types of losses can quickly become catastrophic when inappropriate leverage is used.

For these reasons and others discussed in Option Trading Risks, there is a common misperception that options are a riskier investment than common stocks. The truth of the matter is that stocks have certain unique risks that present a higher probability of loss than certain option related risks. As in the case of options, these risks unique to stocks can be reduced or eliminated through the use of appropriate hedging strategies. Most stock investors, however, fail to hedge against these risks and leave themselves exposed to potentially catastrophic losses of capital.

The risks related to options are presented and discussed extensively in Option Trading Risks. The following discussion examines the risks unique to holders and short-sellers of common stocks. The examples below do not include amounts paid in commissions for the stock and/or options transactions.

Higher Potential Loss In Dollars With Stock

Any discussion about the suitability of options as an investment usually starts with a warning about the dangers of leverage inherent to options. Most stock investors hear the word “leverage” and automatically conclude that options must be a riskier investment vehicle than stocks. This is not necessarily true.

The leverage afforded by a call option makes it possible for an investor to control 100 shares of the underlying stock with a much smaller dollar investment than would be required to buy 100 shares of the stock itself. While the option holder and stock holder both have unlimited profit potential (there is no limit on how high the stock price can increase), the option holder has a lower risk of monetary loss due to the smaller amount paid for the option. Even if the underlying stock falls to zero, the call option holder cannot lose more than the small premium paid for the option. In contrast, the stock holder risks losing the significantly higher dollar amount invested directly in the stock.

For example, let’s assume that the ask price for Qualcomm (QCOM) stock is $40.20. An investor could purchase 100 shares of QCOM for $4,020. Let’s further assume that the QCOM May 40 call option is asking $2.48 per contract. One call option that controls 100 shares of QCOM would cost just $248.

As you can see, the call option buyer could acquire almost the same profit potential in QCOM as the buyer of the stock but with a much smaller initial dollar investment. More importantly, the stock holder has a much higher risk of loss in dollar terms than the call option holder. If QCOM stock declines to zero, the stockholder would lose the entire $4,020 paid for the 100 shares of stock. The call option holder’s potential loss, however, would be limited to just $248. Clearly, the leverage available through a call option provides a less expensive way to participate in the unlimited profit potential of the underlying stock with far fewer dollars at risk.

Higher Risks Selling Stock Short Than Buying Puts

The only way to profit from an expected decline in the price of a stock is to sell it short. Selling Short simply means borrowing stock from your broker that you don’t own and selling it in the market. The short seller immediately receives the proceeds from the sale of the stock. If the stock goes down, the short seller buys it back at the lower price, turns the shares over to the broker (plus commissions and interest) and pockets the difference.

For example, you might sell short 100 shares of American Express (AXP) at $50 per share. You immediately receive a credit to your account for $5,000. When the price drops to $45, you buy 100 shares of AXP, turn them over to your broker, and keep the $5 per share difference ($500) as your profit. Buying the shares back is called “covering the short position”. As you can see, the short-seller is able to profit from a decline in the stock by paying less to cover the short than he received from the sale. You also might have noticed that our short-seller did not have to spend any of his own money on the trade.

There are several significant risks of selling short. The first and most important risk is that the potential losses from a short sale are unlimited. If the price of the stock rises above the short-sale price, you will eventually have to pay more to cover than the amount you received from the sale. Since there is no limit on how high the price of a stock can rise, the potential loss to the short-seller is unlimited.

Let’s examine this scenario using the facts from the above example. Instead of declining $5 in price after the short sale, assume that AXP rises by $5 per share to $55. If you cover at $55, you must pay $5500 for stock that you sold for $5000. The resulting loss would be $500. Imagine the potential losses if the stock unexpectedly jumps up by 10 or 15 points.

Another risk of selling short is that the expected drop in price takes too long to happen. The timing of the stock’s decline is important because the short seller must pay interest to the broker on the stocks borrowed for the short sale. The longer it takes for the stock to drop, the greater the interest payments. As the amount of interest paid increases the more it eats into the potential profit from the trade.

A third risk is getting caught in a “short squeeze”. A short squeeze happens when a stock that is heavily shorted starts to rise in price. As the short sellers scramble to cover their positions, their intense buying causes the stock price to rise -even higher and potentially at an accelerated rate. The short seller’s reasonable losses on the trade can quickly turn into catastrophic losses.

A fourth risk is that the brokerage firm might demand the stock back from the short seller. This could happen at any time and could cause an unexpected loss.

Because of these risks, most stock investors never even consider selling short. Stock investors who refuse to sell short are at a disadvantage because they have removed the one strategy available to profit in bear markets or bull market corrections. Fortunately, the options market offers a less risky alternative.

Instead of selling short, you could buy a put option on a stock which you expect to drop in price. For example, let’s assume that JP Morgan Chase (JPM) is trading at $40 per share and its MAY 40 put option is trading at $2. Let’s also assume that a stock trader sells short 100 shares of JPM at $40 and you buy one MAY $40 put option asking $2 per contract for $200.

The short position will begin showing a profit of $100 for each $1 delcine in JPM’s stock price below $40. The potential profit is limited to the amount collected for the stock. The potential loss is unlimited since there is no limit on how high JPM’s stock price can rise.

On the other hand, your put option will begin showing a profit of $100 for each $1 decline in JPM below $38 ($40 strike price minus $2 premium paid for the option). The profit potential of the put is considered unlimited even though JPM stock can decline only to zero. When measured upon expiration for the option, each $1 decline in JPM stock below $38 will show a profit of $100.

The potential loss on the put option is limited to the amount paid for the option-$200 in this example. When measured upon expiration of the option, if JPM stock is trading above $40, the put option will expire worthless but the loss would be limited to just $200. In addition, unlike the short-seller, you would not have been required to use margin to buy the put.

As you can see, the buyer of a put option has almost as much profit potential as the short seller, but the risk of loss is significantly limited. The risk is just the total purchase amount for the put.

Stocks are Uni-Directional While Options Can Be Either Uni-Directional or Multi-Directional

An investment in a stock shows a profit only if the stock moves in the single direction required by the trade. For long positions, the stock price must increase in value above purchase price. For short positions, the stock price must decline below the short sale price. In most cases, a stock investor will not have both a long position and a short position in the same stock. This means the stock investor must be correct in his expectation of the direction the stock will move before deciding whether to go long or short the stock.

In contrast, call and put options have multi-directional capabilities. They can be used in various combinations to create positions which can profit from multiple expectations about price movement in the underlying security. There are:

(1) Bullish strategies to profit from expectations of moderate or explosive increases in price,

(2) Bearish strategies to profit from moderate or extreme price declines,

(3) Neutral strategies to profit from small or no price movements in either direction, and

(4) Strategies to profit from expectations that price will move dramatically where the direction is not clear.

Options can also be used to hedge other option positions and/or long or short positions in stocks. Hedging strategies are used to reduce risks while maintaining profit potential of a position. The above strategies and hedging strategies are discussed in more detail in Advanced Options Trading.

Conclusion

It should now be clear the general statement that stocks are less risky investments compared to options is not only incorrect but is misleading. Stocks have certain characteristics that pose unique risks for buyers and short-sellers. While options too have unique risks, they can be used in ways that stocks can’t to reduce and/or limit certain risks. As with any investment vehicle or strategy, you will have a greater chance of success if you completely understand the risks and have a plan of action to address them as they arise.

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Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.

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