Are Investments in Options or Stocks more Risky?

March 24, 2011 at 12:02 am Leave a comment

Are Investments in Options or Stocks more Risky?

A typical situation for people who once put their name in a subscriber list, and now are identified as potential investors:

A call from a broker, mostly from a firm that I never heard about, and has the best program on earth, certainly making you rich in a short time and you just have to open an account.

Let u go through a short stereotypical outline of the phone conversation:

How are your stock market investments going?
Excellent (my answer)
The typical standard question of a phone sales person: What are you investing in?
Futures and Options – my answer.
The standard reply: Oh, you are taking on higher risks.
All broker telephone sales people are trained to say this sentence.
It is almost funny. When I reply: I don’t think so. That immediately separates pros from phone solicitors:
“Of course you do?”

Such ignorance usually brings those phone calls to a friendly end: “I do not spend time for that.”
Now let us bring means, background and facts into this case: Taking the telephone sales talk out, where the person on the other side is trained to play with our emotions of fear and excitement, we come to the following facts:

When I buy 100 shares of a stock with a value of $120/share, that moves about 1-2% a day, we want to calculate the risk or exit point, if the trade does not go our way. Capital preservation is a key essential for successful financial market investment. If prices break through a major support line or short term momentum line, this should define our maximum loss and exit point to the downside.
In our case, we assume support being 4% away from our point of entry. Then we know that we are risking: $480 on a $12,000 investment.

To control 100 shares one needs to buy 1 Call Option Contract, for: $1.20 x 100 = $120.

We now control for the duration of the call option contract the same amount of shares: 100 and what is the risk involved?
The maximum we can lose: $120.

Making things equal, we are going to risk the same $480 and buy 4 call option contracts.

With the same amount of risk, we are now controlling 400 shares for the duration of the options contract.

Talking about risk, always involves the worst case:

Overnight news make the stock drop to $90 at the next day open and we want to get out:
Stock holder loss: $3,000
Option holder Loss: $420 (there will still be some time value in the option).

But actually, the broker does not want us to do so many trades, we shall rather sit tight and wait until the share is going up again, but the next day prices drop: $79/share: $4,100 loss for the stock holder.

What will be the answer when we call your broker and ask what is going on:

“Hold on to it, it is gone get BETTER.”
Yes right, now the share has to climb 51% to get us back to break even.

We want people to take their financial freedom into their own hands and teach them techniques of how to invest in the markets, making money in all directions and rather having a buy and sell, than a buy and hold strategy.
With a buy and sell strategy we always have a target and at the target we either take the entire position off, or pull the stop tight, to not allow realized profits to slip away.

Let us assume we wanted the share price to go to $125 in the next 5 days and cash out. What would be the results:

Stock holder: Selling 100 shares at $ 125, gaining $500 – which equals a 4.2% return on capital.
Option Holder: Selling 4 option contracts – but what will be the value of the option?

To calculate the result of the future option value, we need to understand the impact of the option influencing parameters, that are made out of: The relation an option moves with the stock, time decay and volatility change. It all sounds more complicated than it is. We provide you with a model where you can do the calculation in seconds on the trading platform or on our member section of the website.

In our case the simulator lets the option price increase by $1.96. Calculating $0.02 slippage, we come to a value increase of the option of: $1.94 x 400 Shares controlled = $776, or 61% return on capital.

Based on those results, the option investor gained 55% more profit and in total risked about $400. While the risk of the shareholder can be substantial on defined amount of gains.

So finally, who is taking more risk: the option investor or the share holder?
Now that you know the answer, it is up to you to learn the mechanics to be able to apply such investment strategies. To be a successful financial market investor, skills and market details need to be learned and this is what NeverLossTrading is successfully teaching. We believe in hedging and leveraging any market investment: from Mutual Funds, Stocks to Options and Futures. You will leave our workshop fully setup to follow the NeverLossTrading concept.
Take your financial freedom into your own hands:
“If you do not care about your own money, nobody else will.”
Check us out at: http://NeverLossTrading.com

Entry filed under: Investor Education, Stock Market. Tags: , , , , , , , .

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