Balancing Profit and Risk in Options Trading

July 17, 2009 by  
Filed under Options Trading

No investment that is profitable comes without some level of risk. Without risk, there’s no chance of profit. This is why investors use several tools and strategies to try to maximize the potential profits and minimize risk when speculating about future options prices. Here, we’ll discuss some of the options trading strategies employed to do just this.

Long calls are the simplest trade in options, and are best for beginners to start with in the world of options trading. These calls give the right to buy the underlying asset at a specified price (also called the ‘strike price’). The cost of this option is called the ‘premium.’

When a strike price falls below the market price, an option is said to be ‘in the money’, and when it’s above, it’s referred to as ‘out of the money’. No matter what the market price is at the time of an option’s purchase, the investor is guessing the price will rise above his cost prior to the contract’s expiration date.

Profit potential with long calls is infinite, as the market price of a stock or bond can rise indefinitely; the amount of which determines the amount of profit an option trade makes.

However, there are some risks involved. Prices rise and fall in cyclical patterns, so falling is always a possibility – even with the best research and speculation in place. The good news with options is that they cost a fraction of the actual market cost of the asset, so losses can be controlled.

Options trading uses leverage, or the ability to control more than you actually own, with a much smaller investment. Option contracts are typically priced at about 5%of the underlying market price, meaning the leverage is 20:1. However, the option must be liquid to be advantageous. Ensure that the open interest, or total outstanding contracts, is no less than 100 – the higher this number is, the better.

Puts are contracts to sell an asset at a set price before the date of expiration. These are utilized in times when an investor speculates the price of an asset will fall, as they sometimes do.

This option is much like selling stock short, and involves borrowing the shares and selling them immediately. The difference is your profit, unless the price rises; then, you owe your broker.

Long puts allow you to speculate the market price will fall below the strike price. Risk is capped at the amount paid for the put option contract – however, profits are also capped since the price can’t fall below zero.

Other tips that will help you in options trading is to find options with underlying assets that are liquid and showing daily trading volume of over 500,000. You’ll also need to allow enough time between the purchase date and expiration date to accurately assess the market trend and price. Though options near the expiration date are much less expensive, the risk is much higher that they either won’t change at all or will decline in value.

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