Lower Your Risk with Stock Options

Stock options are a great tool for many outcomes. We can use them to get better leverage on a trade, create more consistent profits, bring in cash during a stagnant market, hedge positions, and the list of uses goes on.

Let's Look At SPY

It's easy to look at a trade like this SPY trade and think, "that trend is continuing, should buy the stock." At first glance the trend is bullish, and it is a natural trade.

As you look closer though you may discover this simple trade is going to take a lot of money. With a quote price around $218/share, a simple 100 share trade will require $21, 800.

For various reasons, this is an unattainable amount of cash for some people. Some may not have that much cash available to trade, and for others, they may not want to risk such a large amount of capital.

Here the call option can come in very handy.

Instead of buying the stock for $218/share, you could buy the $218 call option for only $2.90. This makes the entire investment only $290.

The lower capital requirements are nice, but there is an additional benefit to using the call option on this trade: you also are lowering your actual trade risk.

If you were to place the straight SPY trade, you would need to place your stop somewhere. $213 would represent a good price to set your stop. This would limit the overall risk of the trade to $500.

While a $500 risk is certainly manageable, consider the risk of the call option. Even if the option were to lose 100% of its value, it would still only represent a loss of $290 as opposed to $500. This is nearly half of the risk taken when purchasing the stock outright.

Here you see a situation where the call option not only lowered the capital cost but also lowers the actual dollar for dollar risk. This chart recaps the benefits of the call in this situation.

Stock options can be tricky, but with the right training, they can be a fantastic complement to your overall trading strategy. If you routinely find yourself in situations where the stop price is "too risky," consider the call option instead. As a long synthetic trade, the call option will:

  • Lower your capital requirements
  • Lower dollar for dollar risk
  • Increase your ROI

Options aren't for everybody, but traders who do learn to work with options will find they can be a very flexible tool.