Are options really riskier than stocks? Should a risk averse investor really shun the option market and stick to stocks and bonds? Most of CFA candidates should immediately be able to respond to these questions by: “It depends!” However, this is hardly a satisfactory answer and we find it quite relevant for CFA hopefuls and the general public deserves a more complete answer.
In reality, there are a variety of ways one can use options (and other derivatives for that matter, but this post will focus on options). There are two general categories of ways one can utilize options:
1- Hedging/Risk management: To provide protection against an existing exposure or risky position.
2- Speculation: Attempting to profit from fluctuation of the underlying price.
There are a variety of ways to implement these two types of positions but let me just explain some of these here. Since hedging strategies are executed to reduce risk, they are by default less risky than a stock investment. For instance, if an investor has a position in Facebook at $50/share and wishes to protect her downside, she may buy puts to lock-in a minimum selling price.
Speculating with options can be more or less risky than speculating with the underlying stock. When unfamiliar with the trading of options, it is tempting to compare the purchase of the stock to the purchase of calls for example. In most cases, buying a call will indeed be more risky than buying the underlying stock. The same goes for puts. How much more risk depends mainly on the strike price and maturity chosen.
Here is chart showing the price movement of March 2014 60 call on Facebook stock. To show the contrast between the call performance and the stock performance, both are displayed on the chart. The performance of the S&P 500 for the same period is also shown.
We can see the huge variation in price for the option, reaching as high as 500%, then returning to the original price, before jumping back up. Meanwhile, Facebook’s stock, which had a stellar performance, seems to be barely budging. The chart above illustrates why people usually claim that options are risky. Someone who had invested in March $60 calls back in September would have tripled his money after enjoying a heart attack inducing roller coaster ride. Let us see what would have happened with a March $40 put during the same time period:
As you can see, the value of the March $40 strike put option has dwindled by 90% during this time period. The point here is that if an investor speculates by buying out of the money calls or puts, the risk will indeed be much greater than investing the same amount in the underlying stock.
However, before we conclude that options are riskier, let us make two points. First, since options provide leverage, an investors can put a lower amount of money at risk when buying calls or puts. In other words, we cannot compare a $10,000 investment in Facebook’s stock with a $10,000 investment in Facebook calls. A full explanation would require devling into the Greeks and is beyond the scope of this article but just visualize the following scenario.
Facebook is trading at $55 and the price of a $60 Strike March call is $3. If, at expiry the price moves up to $70, let us compare the performance of the stock versus the call:
Stock: Gain of $15 or 27% ($70-$55)
Call: Gain of $7 or 233% ($70-$60-$3)
Therefore, given the scenario above, an investor would spend $5,500 to buy 100 shares of Facebook and realize a gain of $1,500. An option investor could buy only 2 call contracts (of 100 shares each) and spend $600 ($3 X 100 shares X 2 contracts) and realize a gain of $1,400 ($7 X 100 shares X 2 contracts) which is about the same gain as the stock investor who spent $5,500! The best part is that the worst that can happen to the option investor is losing his $600 investment.
I hope the example above allowed you to see how options and stocks behave differently which means you have to be careful when comparing their performance and risk characteristics.
The other important point to make when contrasting options and stock as a speculation medium is that most option trader do not simply buy calls and puts as described above. They implement more complex strategies by combining many options or a combination of stocks and options. There are dozens of option strategies, some are used to hedge, some are used to speculate either on market/security’s direction or on volatility. We explained one of these more complex strategies previously but there are many resources online where you can find more information on option strategies.
Since options are more complex instruments than stocks, it is advisable to learn more about them before trying to trade them. While investing in a stock only requires the investor to forecast the direction of the stock price (up or down), options has another component which is volatility. Failing to understand this is a great recipe to see your trading account melt like ice cream on concrete on a summer day…