| Like all forms of investment, there is risk associated | | | | to see rapid price movements in the underlying asset |
| with trading options too. But this risk can be | | | | which affects the strike price of the option. |
| managed with some basic knowledge. | | | | You must be wondering - with all these risks, how |
| Lets examine the various risks associated with | | | | am I supposed to make the right choice? The irony is |
| options: | | | | that an option itself is a form of risk management. |
| 1) Price Uncertainty - | | | | The leverage you get from options helps to manage |
| No one can say with absolute certainty where the | | | | price risk by protecting your principle. Lets have a |
| price of a stock is headed. You wont know whether | | | | look at an example: |
| the Johnson & Johnson (JNJ) is going to be | | | | Suppose you want to buy 100 shares of Apple |
| higher tomorrow, in a week or in a month from | | | | (AAPL). At the current market price of $100, this |
| today. This uncertainty regarding price poses one risk. | | | | would cost you $10,000 (not including broker |
| 2) Timing Risk- | | | | commissions). Thats a lot of money for novice |
| Options, like bonds and futures, have an expiration | | | | investors. But, using options you could control 100 |
| date. The holder of the contract has to decide | | | | shares of Apple by buying a single options contract. |
| whether to exercise the option to buy or sell the | | | | Depending on the strike price you would be able to |
| underlying asset on or before that date. Getting the | | | | control the 100 shares for less than a fraction of the |
| timing right is imperative because the amount of | | | | cost of owning the shares. If you bought the 100 |
| profit or loss is dependent on when that option is | | | | shares instead, you could stand to lose a larger sum |
| exercised. | | | | of money if the stock were to decline significantly. |
| 3) Volatility Risk- | | | | However, if you used options you would only stand |
| In addition to the price and timing risks, there is | | | | to lose the option premium. |
| another risk - volatility. This is a measure of much the | | | | Another way to manage your risk would be to |
| price of an option can vary during a certain period of | | | | identify the various risks and quantifying them i.e. |
| time. During periods of high volatility it is very possible | | | | measuring the delta, theta, vega among others. |