Warren Buffet routinely uses stock options to reduce risk in stocks and purchase stocks at a reduced cost. If you are using stock options, they should be less risky than simply owning stocks. You can even trade stock options in your IRA. That’s the simple answer, but read on to find out why it’s true.
Dollar for dollar, trading stock options is less risky than trading stocks for a set period of time. For example, if you thought Microsoft was going to increase in value during the two months after Vista launched, you could have bought the stock for around $ 29.50 per share or bought a $ 30 strike price in January 2007 for $ 0.70 per share. Share. Since a stock option covers 100 shares, the cost of the option is $ 70.00 to control 100 shares versus $ 2,950.00 to own 100 shares. If the stock rises to $ 30.00 per share, the option will be approximately $ 0.92. You can calculate this using a stock option price calculator. That little movement in the stock results in a 30% return on the stock option and a 1.7% return on the stock. This is called leverage and it is a hallmark of stock option trading. On the third Friday in January 2007, Microsoft rose to $ 31.11 per share. With your call option, you can buy shares at $ 30.00 or simply sell your call option at $ 1.11 per share, generating a 58% return on the stock option.
What if Microsoft goes down? If it goes from $ 5.00 to $ 24.50, you have lost $ 5.00 per share on the stock, but the most you lose on the stock option is the amount you paid or $ 0.70 per share. That’s a lot less risky than owning stocks if you mess up and the stocks go down.
When you have a long (buy) position in a stock option, your risk is always limited to the amount you paid and it is always much less risk than owning the shares. High risk in stock option trading occurs when you sell short options (sell) and do not own the shares for a call option that you sell or have the cash for a put option that you sell. It is not necessary to do this.
Did you know that it could even eliminate the need to forecast whether a stock will go up or down? You can use direction-neutral stock option trading, such as horse trading, to generate income if stocks are moving up or down. The risk in these operations is limited to their initial cost. Sometimes you can even set up some neutral stock option trading at no cost.
Stock options can also be used to reduce your risk in stock ownership. If you own a stock that doesn’t move, something most stocks do about 80% of the time, you can sell a call option at a higher strike price than the cost of your share. For example, suppose you paid $ 25 per share for shares and you sell an exercise call option of $ 27.50 to $ 0.50 per share. If the stock rises to $ 27.50 at the expiration of the option, you have to sell the stock at $ 27.50. He would make a total of $ 3.00 per share ($ 2.50 in shares and $ 0.50 in options). If the stock falls or does not move above $ 27.50 at expiration, you can keep the shares and the amount you were paid when you sold the call option. That’s like generating your own dividend of $ 0.50 per share. It also reduces your share cost by $ 0.50 per share. Therefore, the most you can lose on that share is 24.50, not the original $ 25.00.
So to answer the question, trading stock options done correctly has much lower risk than trading stocks. Stock options allow you to diversify much better with the same amount of capital. The risk in stock option trading that is not present with stock trading is its limited life. Stock options expire. This means that your forecast for stock movement must occur within the time frame of the options you use. This can range from 1 day to almost 3 years.