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Monday, February 25, 2008

Are Stock Options Risky?

Investing in stock option could a good way to lower your risk element in stocks. This is one of the strategy that is adopted by the stock market experts who has made millions in the stock market. Stock option can actually thus, lower your risk. In a given situation you would realize that investing in stock option is a far less risky proposition as compared to trading in stocks.

For example, if you thought Microsoft was going to increase in value over the two months after release of Vista, you could have either bought the stock for around $29.50 per share or bought a $30 strike price Jan ‘07 call for $0.70 per share. Since a stock option covers 100 shares, the option cost is $70.00 to control 100 shares versus $2950.00 to own 100 shares. If the stock goes up to $30.00 per share the option will be at about $0.92. You can calculate this using a stock option pricing calculator. That small movement in the stock results in a 30% return on the stock option and a 1.7% return on the stock. This is called leverage and is a hallmark of stock options trading. On the third Friday in Jan ‘07, Microsoft was up to $31.11 per share.

Using your call, you can buy the stock at $30.00 or you can just sell your call for $1.11 per share, generating a 58% return on the stock option. What if Microsoft drops? If it drops by $5.00 to $24.50, you have lost $5.00 per share on the stock but the most you loose on call stock option is the amount you paid or $0.70 per share. That is much less risk than owning stock if you are wrong and the stock goes down.

Investing in stock option and making the right decision can actually get you a profit irrespective of the direction of the stock movement. You could use direction neutral stock trading option.

On the whole, you would observe that based on available facts it is seen that stock trading has far greater risk as compared to investing in stock option. Stock option provides you tremendous flexibility and let you diversify. However, stock option has a limitation. They are deals that are made for a specific time frame and thus, the expiry of the time period puts an end to all the good times. They have a time limitation. The stock option could be for any specific time period ranging from 1 day to 3 years however, your predictions have to come right within this time frame.