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Trading Strategies, Profit and
Risk
Risk isn't inherently bad. Without it, there would be far fewer
opportunities for profit. In particular, there would be no
options market at all. No one would have to speculate on price
direction or other factors, since risk always implies
uncertainty about the future.
But risks come in different flavors and degrees. Let's examine
some trading strategies with an eye toward risk...
Long Calls
The simplest options trade, the one usually first executed by
investors moving beyond stock or bond investing, is the long
call. A call is a contract that confers the right to buy an
underlying instrument at a set price, the strike price. For
this right, the buyer pays a 'premium' - the cost of the
option.
When that strike price is below the current market price, the
option is said to be 'in the money', when above it's 'out of
the money'. But whatever the market price when the option is
purchased, the buyer is speculating that the market price will
be above his cost (strike price + premium + commission) before
the option expires.
The amount by which the market price is above that cost
determines the amount of profit. Since, in theory, the market
price can rise indefinitely, the profit potential is called
'uncapped'.
Unlimited potential profit, but not without risk. As the famous
banker J.P. Morgan said when asked what the stock market would
do: 'Prices will rise, and prices will fall.' When the price
falls below, or fails to rise above the cost of the option the
investor loses money. In this case, however, the risk is
obviously limited to the amount of the option (plus a small
commission).
These kinds of options make for wise investments for those with
limited experience but who want to take advantage of the
additional leverage provided by options. Leverage is the
ability to control more than you own. Since the option price is
typically around 5% of that of the underlying stock, the
leverage is 20:1. This multiplier effect is one thing that
makes options so attractive.
Be sure the option has adequate liquidity, though. Open
interest (the total outstanding contracts) should be no less
than 100. The higher the better.
Long Puts
J.P. Morgan was right, prices sometimes fall. Sometimes they
fall far and for a long time. When an investor judges this is
likely, the next simplest options trading strategy can be
employed: buying a put.
A put is a contract granting the right to sell an asset at a
set price before or by expiration. It's slightly more difficult
to understand, since the idea of selling something you don't
own is odd.
Just like shorting stock, the trade (imagining the option were
exercised) actually involves effectively borrowing the shares
then immediately selling them. However, the investor never sees
the underlying mechanics. As with shorting stock, the investor
is on the hook for the 'borrowed' amount.
In this scenario the put buyer is speculating that the market
price will fall below the strike price.
This is another situation in which the maximum risk is capped,
this time by the price paid for the put. The reward too is
capped, since the market price can't fall below zero. The
maximum profit in that case is the strike price minus the cost
of the put.
As with calls, ensure you choose an underlying instrument with
adequate liquidity, preferably shares of over 500,000 ADV
(Average Daily Volume). Look for open interest amounts over
100.
When trading options always be sure to select those with enough
time left to judge the market trend. An option near expiration
will be cheaper (options contracts are themselves actively
traded), but carry higher risk. And risk is a bad thing...
sometimes.
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