Moreover, according to Jeff Opdyke, in the September 4, 2009 Wall Street Journal article"More Investors Try the Options Play," Charles Schwab Corp reported that 47% of its investors trade options, up 7% from last year. Even with all this activity,it's not a safe assumption that all options are a sure bet. Be aware that options can be risky, depending on the type of option.
Essentially, an option involves the right or obligation to buy or sell a stock or index at a certain price (the strike price), on or before a certain date.
Options at Risk
Selling uncovered calls (in which the investor doesn't own the underlying stock) can be very speculative, with profit limited to the premium, and the loss virtually unlimited.
Selling uncovered calls are for investors who are bearish on the underlying stock. The purpose for the investor is to generate income by collecting the premiums, if and only if the option expires worthless (and 30% of all options do expire worthless).
However, if the stock price goes up dramatically at expiration, the writer will be required to sell the stock to the options buyer at the lower strike price by buying the stock on the open market at the higher market price. Since there is no limit on how high the stock can climb, the risk has no boundaries.
Example of Selling an Uncovered Call Option
Assume that an investor sells a December naked call on stock X with a strike price of 60, when the stock is trading at 56. The premium received was $2, so if one contract was sold, the writer gets $200. Say on expiration date the stock has jumped to 70. Since the strike price is less than the market price, the buyer will exercise his right to buy the stock at 60. The seller has to buy the shares at $7000, and is obligated to sell the shares at $6000, a loss of $1000. Since the writer has already received $200, his loss is equal to $800.
The break even point for the seller is equal to 62 (the strike price plus the premium). As long as the stock price remains at 62 or below, the buyer will not exercise his right and the seller will incur no loss.
Mitigating Risk- Hedging
Trading stock options is not always a high risk investment. For many investors, options can be an effective way of managing risk, as a way of limiting potential loss, such as protection if a stock held decreases in price. Say an investor is concerned that stock X’s stock price is going to drop. The investor can buy a put option, giving the investor the right to buy at the strike price, no matter how much the stock price sinks below the strike price. This is somewhat like an insurance policy, with the premium paid (usually just a few dollars) as its cost.
 |
