Investing in options

How come there are not a lot of people controlling risk with option strategies?

Stock, bonds and mutual funds are the investments that are more commonly held in the portfolios of most investors. However, there are many other investments out there including futures, options and other derivatives. While these investments can provide investors with additional ways to manage risk and generate profits within their portfolios, they are generally complex investments that are more expensive and risky than stocks, bonds and mutual funds.

Options are investments that an investor purchases to give them the right to buy or sell an underlying security (such as a stock or bond) at a specified price on or before a future date. The investor is not obligated to exercise the option, however, if the investor exercises the option he/she is agreeing to purchase or sell the underlying security based on the terms in the options contract. If the investor does not to exercise the option, the option will expire and the investor would have only lost the amount of money he/she used to pay for the option (i.e., the options premium).

While options can be used for a variety of reasons, one way to hedge or limit the risk in an investment portfolio is to use options. Options can be used to limit the downside risk of the securities in a portfolio by acting as an insurance policy if the price of those securities decline. However, the cost of that insurance can be high especially if you are using options to hedge a large portion of your portfolio. The premium for an option used for hedging is generally based on the volatility of the underlying security and the length of the option. The more volatile the security is or the longer the option is, the higher the premium.

The options premium is only one expense of using options. If you exercise an option, you are agreeing to buy or sell the underlying security. Buying or selling this security will generate trading costs such as transaction fees and commissions. These additional costs can reduce any gains you may have earned as result of exercising the option.

Options, in general, are complicated and risky investment vehicles because they require the investor to not only predict whether the price of a security is going up or down but also the amount and timing of that movement. This requires a good understanding of the underlying security itself as well as the particular options strategy being used to speculate or hedge the security. Ongoing research on the price and market movements for that underlying security is necessary to provide the investor with an understanding of their potential gains and losses from the use of options.

While options can provide an investor with additional ways to enhance or protect their portfolio they should be used as a compliment rather than a substitute for diversification due to their complexity, cost and risk.