Buying options provides a trader with limited risk plus the potential for unlimited reward. This particular risk profile is what many novice traders find appealing. Risk management using this type of position can be very simple to implement.

Buying an option, whether on a stock or futures commodity, means that the purchaser has the right, but not the obligation, to exchange his option for the underlying financial product. It is this right to exchange (called exercising an option) that gives the option value. That value will change as the the price of the stock or commodity changes. At anytime during the life of the option, the holder can either sell it or exercise the option. Usually the option is simply sold back to the market.

Because the buyer has only an option and not an obligation, there is limited risk. No matter how far the actual price of the underlying moves against a trader, he will only lose the purchase price of the option. The trader is not obliged to buy back the underlying stock or commodity at a loss. Therefore the lowest price an option can reach is zero.

The investor knows upfront exactly how much risk he is undertaking. The simplest risk management technique involves buying as many options as you would the stock. So, if you wanted to buy one hundred shares of stock, you would purchase one option contract. It is a conservative method that allows you to ride out any ups and downs in the market. The price you pay for one contract is a fraction of what you would pay for one hundred shares.

Buying options is a limited risk method of increasing portfolio returns. The amount invested is far less than what is required to buy the best stocks though. You can either keep the rest of your funds in cash or diversify into other investments.

Tags: , , ,

Tagged with: • • •

Filed under: Options and Investments General Info

Like this post? Subscribe to my RSS feed and get loads more!