How Trading With Options Can Lower Risk?

Trading options is a way to trade underlying stocks, commodities, indexes, or other financial products without owning the asset. It can be beneficial for investors who are not experts at trading securities but want to have potential profits from fluctuations in the market.

Use spreads

One way to lower risk in trading with options is to take advantage of the ability to use spreads. A spread is where a trader takes positions on two or more options contracts typically related and have different strike prices and expiration dates. By doing this, the trader leans toward the more favorable side in market fluctuations and limits risk if something goes wrong.

Sell puts

Many investors who trade stocks prefer to sell their shares at a set price rather than waiting out rises or falls over time. Selling puts allows investors whose portfolios are showing losses to continue profiting short term by selling off their stock at a premium, even if it ends up falling below the put’s sale price. The premium received from writing puts can help investors cover losses, lowering risk.

Use spreads with puts

Another way to reduce risk in trading options is to combine puts and option spreads for more stability. Selling an option contract is risky. If the underlying security rises above the strike price before expiration, the seller must purchase shares at a market value even though they sold initially at a lower value. By using spreads in conjunction with writing put contracts, investors may balance out any potential losses incurred when selling puts on their portfolios.

Use covered calls

A covered call is a game plan that investors use to protect their stocks and limit potential gains. The investor buys security shares at one price, sells call options for another price, and then closes the position by purchasing the underlying asset as soon as it reaches the target price or before expiration. This only works when done correctly.

Use zero-coupon bonds

Investors can also use zero-coupon bonds in an attempt to lower risk. A zero-coupon bond is sold at a discount and paid for in full on its maturity date, so it does not pay interest. It can be advantageous because it provides income that might otherwise take years and allows investors to receive their money back without waiting for an annual return. It will, however, further diminish the investment’s value each year by adding accrued interest onto the original sum — making long-term trades risky business.

How does trading with options work?

Once you purchase an option, you are given the right to trade a specific number of shares within a specific time frame. For example, if you buy five call option contracts to trade AAPL stock at $150 before October 20th, you agree to pay around $4 per share for the right to sell 100 AAPL shares at $150 each at any time between now and then.

If after that week AAPL is trading below $150, your calls will no longer be valid and can be ‘assigned’ back to the original seller. The assignment price would be the current market value ($138 in this example), and you will have to sell 100 AAPL shares at this price. In return, the option seller would receive the $4 per share they requested for their five contracts.

If instead, AAPL is trading above $150 on October 20th, then your calls will still be valid until expiration. If you choose to utilize your right to sell your shares, then you can pocket a nice profit without having to buy or wait for them in the open market. So if after a rise in share price from a low tick of $138 on October 20th morning’s opening bell, traders come out and bid up AAPL stock again. It is now trading at $155 by noon, then exercising your calls would result in a $10 per share profit ($155 – $138 = $17, and 100 x $17 = $1,700) minus the cost of your options.

Photo by Alexandr Podvalny from Pexels