The Secret to Reducing Risk with Options
Many investors do not consider using options to help them in reducing their risk with other types of investments. This may be because options have been thought to be risky investments in and of themselves. However, the truth is that options can be a great way to hedge against risk and to even eliminate risks in certain cases.
Individual investors as well as large corporate investors and portfolio managers use hedging techniques in order to reduce their exposure to various risks. And, if done strategically, investors can protect their assets from risk of price fluctuation.
One way to accomplish this is through the use of a put option. This is particularly helpful if an investor is holding a significant amount of equity in one or only a few select stocks. In this case, the investor could be opened up to a heavy potential loss if the share price of just one of these stocks begins to fall.
Here, the investor can purchase a put option that will allow him or her to sell a specific stock at a set price on or before a certain time, or expiration date. Thus, should the price of the stock begin to fall, the investor has now “locked in” a specific sell price and can avoid losing any additional funds should the price of the underlying stock drop below the strike price of the put option.
So for example, if an investor owns 1,000 shares of ABC stock, they can “insure” those shares at a strike price that is at or close to a price that they would not lose any money if they had to sell the shares – as long as they were able to do so if needed on or prior to the expiration date of the option.
Keep in mind that when using this strategy, there is a risk and return tradeoff. For example, a reduction in risk will typically mean a corresponding reduction in potential profits. Therefore, hedging shouldn't be viewed as a way to profit, but simply a way in which to reduce potential loss.
Therefore, prior to using a hedge to protect investments, the investor must ask him or herself if the benefits that will be gained from the hedge will justify the potential loss in profit that may have been gained if they did not sell the underlying asset at a certain price.
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