Options can be less risky than stocks

Given this is a value investing blog in name, talking options may not be what you'd expect. And such ridiculous statements like "Options can be less risky than stocks" just show I don't know what I'm talking about. Well, let's look at the math of some scenarios. There are four basic options positions: long/short call/put. Here's how each could reduce risk as compared to holding the same equity.

Buying a put to 'insure' your long stock position - this is the most obvious. You pay some premium, but you assume no downside risk south of the strike price. If the equity crashes, you come out smelling like a rose compared to those with a simple long position, and if it goes up, you still benefit. All for a bit of premium.

Covered call - this is essentially the opposite of the above position. Here you own the stock, but are short a call. If the stock skyrockets, it does so without you, as the call you sold will be exercised away. And you still are on the hook if the thing tanks. But, you get paid for this position. So, if things turn bad for the equity, you'll be hammered. But at least you have a little premium in your pocket. Again, your maximum loss will always be less (by the value of the premium) than just holding the equity.

Cash covered put - This is a scenario in which you essentially hold cash in order to insure someone else's stock. If the stock tanks, it's yours. And if it goes up, it's not. But this is insurance, and you get paid to provide it. So if the equity drops, both you and your friend holding the stock will both lose, but at least you'll have the premium.

Long call with cash to purchase - Most people probably don't do this. The glory of buying calls is that you get all the upside on the stock, but you don't have to come up with the full price of buying it. This lets you control 1000 shares for the price of 100, for example. If the price drops or is even flat, your investment can be a total loss. (This is the most common options position, and why options are seen as risky). What if you were satisfied just buying calls on the 100, though. How would that compare to buying 100 shares? The chart would essentially be the same as the put-protected long equity position. If the stock drops hard, your options are worthless, but you still have the cash. And that puts you ahead of the long stock guy.

So that covers all four basic options and how you can structure each to be safer than simply holding the stock. Each have lower maximum risk and lower maximum gain. What's interesting is that in order to do any of them, you often need greater permissions from your broker than for just buying and selling stocks. Particularly the cash-covered puts will often require quite a bit more permission. Now this just covers the risk, return is a different story that I'll get to in a later post.