   3: What about the risks involved? The main benefit that options give you is something called "leverage". Leverage is a financial term which means that your investment is multiplied. If you buy a stock on margin, you're using leverage. If you buy a house using a mortgage, you're also using leverage. Options are highly leveraged, in that an options price usually swings in tandem with the underlying stocks (never really a 1 for 1 ratio) but usually in a much greater percentage move. When we talk about risks, we have to talk about two of the most basic ways to play the options market. You can either buy options, or sell them. Buy options: Your risk is limited. You can lose a maximum of 100% of the price of the option. If you invest $400 in a call option, you can lose the entire $400. Sell options (naked): Your risk is either unlimited or extremely large. In the case of call options, your maximum exposure is theoretically infinite, since a stocks price can go from just a few dollars to tens of thousands of dollars per share if specific events happen. If you sell a call option on a biotech company, and that company announces it has discovered a cure for cancer, watch out. You could be on the hook for hundreds of thousands of dollars. In the case of puts, your risk is that the stock price could go to zero, and you have the obligation to buy the shares at a fixed price, so your risk is 100% of the option's strike price. Sell options (covered): Covered options greatly reduce your risk when selling options. A short option is considered covered if there is stock or another option which can be used to fulfill your obligations if you get exercised on. In the previous example, if you owned 100 shares of that biotech company, and sold 1 call option on it, the only losses you would incur are "on paper", as you would be forced to sell your shares for less than the market price (but hopefully still for a profit). I don't mean to scare you with the risks involved, but there are some options strategies you should avoid (like selling naked calls). Most option plays you should be involved with are covered - like spreads. Naked puts are very similar to buying the stock outright, so if you are considering buying a stock (like Cisco), you should also at least consider writing naked puts instead. ©2001 xguru, Inc. A Cardinal Factor Company. All rights reserved. |
