Limiting Risk, But Still Making Some Profits

“Calling the Trend” Column, by George Leong, B. Comm.

The rally continues to proceed after another strong up day for stocks on Monday. The DOW closed above 10,400, while the S&P 500 is above 1,100. The major market indices have closed higher in eight of the lastnine sessions and look technically bullish, albeit also
overbought given the buying. Trading volume is somewhat light, which is not what we want to see during a rally, as it could point to a divergence between price and volume. The CBOE Volatility Index (VIX) is relatively low, an indication that traders believe more gains are coming.

My sense is to continue to ride the rally, but also take some profits along the way, as we have had numerous triple-digit gainers.

If you decide to absorb some profits, but still want to partake in future potential upside, you may want to trade some options.

For those of you familiar with options, you know that option trading is not all about rolling the dice and praying that you are on the right side of the trade. The reality is that your risk from an options trade is generally manageable and generally predetermined, as your total risk is represented by the cost of the option trade or premium that you paid. For example, if you buy a call option on a stock, your risk is limited to the cost of the call option; however, your upside potential is unlimited and only restricted by the expiry of the call.

For illustration purposes, let’s demonstrate the limited risk profile of options. Assume you like networking giant Cisco Systems, Inc. (NASDAQ/CSCO) and decide to buy 1,000 shares at $23.84 per share for a total outlay of $23,840. Now say you made a mistake and the price of Cisco plummets to $10.00. You would then be on the hook for a loss of $13,840. Take a look at the alternative.

You can partake in the same 1,000 shares position of Cisco through purchasing 10 call options of Cisco (each contract represents 100 shares). For example, you can buy 10 contracts of the April 2010 $23 Call Option for a premium of $230.00 per contract, or $2,300 total for the 10 contracts. This would enable you to benefit fully from the gains of 1,000 shares of Cisco, but without the major downside risk, assuming the same scenario in that Cisco declines to $10.00 and your options expire. As the holder of 10 call options, you would simply let the expiry lapse and take the loss.

But, as I said, the loss is predetermined and limited to the premium that you put forth, which was $2,300 in this case. Let’s compare. Your loss of $2,300 under the option strategy is far better than the $13,840 loss via the direct purchase of the stock. The only thing is that, if you hold the actual stock, it’s only an unrealized loss, and you could in fact keep the 1,000 shares of Cisco and wait for it to rebound higher. This is a major disadvantage of options in that time is always against you, since options are a wasting asset that depreciates as you move towards the expiry date.

Timing is everything in option trading. I will discuss in detail the concept of time in subsequent columns.

But, overall, if you think about it, options are excellent risk-reward trades for speculators willing to assume of risk of losing the premium.