Saturday, July 01, 2006

Option Trading - Risky?

Option trading is often considered to be very risky and it certainly can be. However, one of the nice things about many option trades is that the risk is limited and is often much less than the risk of stock ownership. Take, for example, a trade I made on Reynolds American (RAI). With the stock trading around $90 a share in early December of 2005, I bought 5 of the Jan '07 $90 calls for $8.70 a share. Since each contract controls 100 shares, I controlled 500 shares of RAI for $4,350 plus a commission of $12.95. By buying the call options, I had the right, but not the obligation, to buy RAI stock at any time until expiration in January 2007 for $90 a share (no matter how high the stock was trading). Of course, as the price of the stock rose, the value of my calls also rose. Had I chosen to buy the stock at $90 a share instead of buying the calls, I would have invested $90 a share times 500 shares for a $45,000 investment (instead of the $4,350 the options cost me).

By buying the calls, I controlled the stock. I gave up the right to collect dividends and I gave up the right to vote in corporate elections. However, I only had to invest $4,350 instead of buying the stock for $45,000!!! My risk was limited to my investment. In other words, even if the stock went to zero I could not have lost more than my investment -- $4,350. If I had bought the stock, my risk would have been more than 10 times greater or $45,000! Yes, owning these long term calls was risky to the tune of $4,350, but it was not nearly as risky as owning the stock and risking $45,000.

Now, let's look at return. I owned my options for only 10 days and sold them for $10.30 a share after the stock moved up. After my commissions, I enjoyed a $773.88 profit on my $4,350 investment. That is a 17.7% return after commissions in only 10 days. When I sold my options, the stock was trading at about $92.85, so had I bought the stock for $45,000, I would have made a $2,850 profit before commission, but only a 3.1% return on my investment.

Obviously, by choosing to buy the call option, I had a lesser risk than I would had I bought the stock. I reaped a 5 fold greater percentage return than I would had I bought the stock. Of course, though buying a call option generally offers a much lower dollar risk and a much higher percentage return than buying the stock, it must be remembered that options do expire. So, if one buys a call and the stock doesn't move up (sometimes very quickly), the whole investment can be lost.

The knowledgeable trader makes careful decisions about what expiration to buy, what strike price to buy, and how much he can pay for a given option. Under the right circumstances, buying a call option can be a very powerful strategy as illustrated by my RAI trade.

Bill Kraft, Editor
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Bill Kraft is the editor of the Option Trader Service at MarketFN.com.

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1 comment:

Mukesh kumar said...

Very interesting and useful information to learn more about option trading. Keep share more number of tips to us. Thank you.

By Stock market Institute in Delhi