Options

The investor can insure all or part of his/her holdings by adopting conservative option strategies. Following is a brief look at some alternatives. Keep in mind that the purpose of this piece is to introduce investors to the idea of using options. It is not designed to teach any specific strategy.

Options were designed as risk-reducing investment tools, and that’s how the intelligent investor/trader uses them.

First, let’s eliminate two common misconceptions about options.

Options Are Not Complicated

The truth: Certain options strategies are complicated; however, you should already be familiar with options because you have been using simple options in your daily lives for years. Think of an insurance policy or a grocery store rain check. (These are puts and calls, respectively.) There is nothing complicated about either of these items. Here’s one example of how options reduce risk for the average investor:

• John is not willing to take the risk associated with a specific investment. For simplicity, let’s say that John has much of his personal net worth invested in the stock market and is concerned that a major decline could erase too much of his portfolio value. True, he could diversify or take money out of the market, but he is also afraid of not earning enough money on the next big rally.

• Mary is a sophisticated trader who knows how to handle and hedge risk. If she can collect a sufficient premium, she is willing to accept a portion of John’s risk. This is how an insurance company operates. John pays a premium and Mary takes that cash and offers specific guarantees. ⁶

• Once Mary takes on that extra risk, she, in turn, finds a satisfactory method to offset all, or most, of her risk.

• By buying and/or selling appropriate options, John can transfer as much of his risk as he cares to eliminate. By trading with Mary, or some other risk taker, John pays the premium and gets his needs met.

• Sometimes the premium is costly, making it difficult for an investor to be willing to buy insurance.

• At other times, adequate protection is available at a very low price.

• Depending on the type of protection that John seeks, it is possible for him to arrange the trade so that he is paid (that is, he receives cash) to gain some protection against loss. This time the insurance is limited. However, being paid to own that insurance is quite attractive to some investors.

Options Are Not Only for Gamblers

The truth: Yes, gamblers love options. It’s a perfect trading vehicle for them. The problem is that these gamblers often lose their entire trading accounts and then blame the professional market makers for taking advantage of them. The bottom line is that gamblers often make long shot wagers, and losing money is the predictable outcome.

However, most traders are not gamblers. Big hedge funds, pension funds, and stockholders of all sizes use options to hedge their risk. There is no reason why you should not be one of them—assuming that you are either concerned about potential losses or are tired of the large fluctuations in the value of your investments.