In the previous two parts of this series, I discussed the use of put options for both hedging and speculative trading purposes. The key learning you can take home from these two parts is that options, if used properly, can help you to control the risk in your investment portfolio.
If you have not heard this before, successful investors and traders will always work out the risk involved in a position if they are wrong before they look at the potential reward if they are right. On the other hand, investors and traders who have little or no investment education will tend to look at the reward first before they consider the risk involved. I hope you will appreciate the importance of risk management in the world of investing and trading.
In this part, I will discuss the use of call options as a means to create low risk trading opportunities. For those who are not familiar with the concept of a call option, it gives the buyer the right to buy the underlying Stock at a specific price on or before the expiration date. Conversely, a seller of a call option undertakes the obligation to deliver the Stock to the buyer at the specific price when the buyer exercises the call option. In principle, a call option offers unlimited reward potential to the buyer and at the same time, the maximum risk will be limited to the amount of the premium paid by the buyer. As the Stock price goes up, in theory the value of the call option will also go up. Hence, buying a call option is a bullish options strategy that can be used by investors or traders if they are bullish on a particular Stock.
Let's say Tom (a hypothetical person) is evaluating a potential trading opportunity on XYZ (a hypothetical company). This Stock is currently trading at $195 per share. Based on his analysis, Tom believes that XYZ will likely go to $210 per share in a month's time. At the same time, Tom is prepared to exit the position if XYZ hits $190. In summary, this opportunity offers a 3:1 reward to risk ratio. If Tom decides to buy 100 shares of XYZ, his total cost of investment will be $19,500. If he is right in his analysis, his potential reward will be $1,500 [($210 - $195) x 100]. If he is wrong, his potential loss will be $500 [($195 - $190)] x 100].
Here is the problem. Despite the potential risk as calculated above, it does not necessarily mean that this will be the actual risk. The reason is that it is possible for the Stock price of XYZ to gap down due to some bad news announced by the company and unfortunately, we all have no control over the Stock price movement after the announcement. Suppose XYZ gaps down to $140 after announcing some bad news. Even though Tom would have placed a stop loss at $190, his broker would exit the position for Tom at $140, resulting in a loss of $55 per share or $5,500 in total.
Now, let's see what would happen if Tom were to buy a call option instead. A call option contract controls 100 shares of Stocks. In this case, Tom will need to buy only 1 call option. He can work out the options theoretical reward when the Stock price reaches $210 and the risk when the Stock price hits $190. It is possible that the reward to risk ratio for a call purchase would be better than 3:1 as compared to the Stock purchase. I know this may not sound convincing to you because I did not show you the exact reward to risk ratio here. The reason is that this is a hypothetical example. However, let me provide you with a better and more convincing reason why buying a call option makes more sense than buying 100 shares of XYZ in this case.
As mentioned above, if XYZ gaps down to $140 due to some bad news, Tom's loss will be $55 per share or $5,500 in total. However, if Tom were to buy a call option, his maximum loss will always be capped at the amount of the premium he paid. In fact, one of the key features of a call option is that it has built in an inherent stop loss mechanism. No matter how low the Stock price goes, the maximum risk will never be more than the amount of the premium paid.
I hope you will appreciate why buying a call option in this case may be better than buying the Stocks. Make sure you get yourself educated on how to use options safely as a trading instrument.
I will discuss some more examples of low risk options strategies in the next part, part 4.
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