Risk with options, Options: Risk vs. Return
Options, in fact, can be used to hedge positions and reduce risk, such as with a protective put. Options can also be used to bet on a stock going up or down, but with relatively less risk than owning or shorting the actual equivalent in the underlying stock.
This latter use of options to minimize risk in making directional bets will be the focus of this article. Key Takeaways Options contracts can be used to minimize risk through hedging strategies that increase in value when the investments you are protecting fall.
If this is the case, options are a great way to hedge against some of the risks an investor will likely face.
Options can also be used to leverage directional plays with less potential loss than owning the outright stock position.
This is because long options can only lose a maximum of the premium paid for the option, but have potentially unlimited profit potential.
Options and Leverage Let us first consider the concept of leverageand how it applies to options. Leverage has two basic definitions applicable to options trading.
- Options: Risk vs. Return
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The first defines leverage as the use of the same amount of money to capture a larger position. This is the definition that gets investors into risk with options most trouble.
The second definition characterizes leverage as maintaining the same sized position but spending less money doing so. Interpreting the Numbers Consider the following example. This risk disparity exists because the proper definition of leverage was applied incorrectly.
Instead of purchasing the shares, you could also buy two call option contracts. By purchasing the options, you spend less money but still control the same risk with options of shares.
Alternative Risk Calculation The other alternative for balancing cost and size disparity is based on risk. If you own stock, stop orders will not protect you from gap openings. If you own the stock, you can suffer a much greater loss, so the options position becomes less risky than the stock position. Looking for a shortcut to calculating risk when trading options?
Buying Options vs. Selling Options (Risk/Reward, Probabilities \u0026 More)
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Options: Risk vs.