Written by A.J. Brown

They Say This Is Reckless. Yeah, Right.

Conservative StrategySo I’ve observed an interesting phenomenon in the trading world. And it has to do with perceptions about what is risky and what is not.

Specifically, I’m talking about trading call options when you have enough money in the bank to exercise the option versus buying a stock with a protective put.

Brokers are quick to condemn the former and condone the latter. The logic goes like this: option trading is risky because you could lose your option premium, but buying a stock with a protective put is conservative because you won’t lose money if the stock price drops.

But this logic simply doesn’t hold up. In fact, the put-call parity relationship says the risk involved is exactly the same. Let me explain…

When you buy an option, you pay a premium. You may resell the option at a loss or a gain. If you’re following a good set of trading rules, chances are you will never suffer a total loss. And you might also make 50% on your investment in a short period of time.

So is there risk? Yes. But it’s manageable.

Furthermore, if you have enough cash in the bank to exercise the option at expiration, the risk is no different than if you buy stock with a protective put.

As I mentioned, some brokers are advising people to buy stocks (in the hope the price goes up), while at the same time advising the purchase of protective puts as “insurance” in case the price goes down.

Does this do anything to reduce risk? Let’s take a look.

When you buy a protective put, you must pay an option premium. This premium automatically erodes your profit potential. Because the price of the stock will have to increase enough to cover the amount of the option premium before you turn a profit. So your profit looks like this:

Profit = Proceeds from Sale of Stock - (Stock Purchase Price + Put Option Premium)

Let’s say your investment in the stock is $1,000. And your put option premium is $200. Your profit would look like this:

Profit = Proceeds from Sale of Stock - ($1,000 + $200)

Essentially, the price of the stock would have to go up 20% before you’d ever make a nickel!

To sum up, the put-call parity relationship says buying a call option and having enough cash in a risk-free interest account to buy the stock at expiration is exactly the same thing as buying a stock and a protective put as insurance.

Brokers tend to label those that buy call options as reckless whereas they tend to label those that buy stocks with protective puts as responsible, conservative investors. But as long as the call buyer has enough cash to buy the stock at expiration, both investors are doing exactly the same thing.

So are both investors responsible and conservative, or are they both reckless? What’s your take?

Best regards always,

A.J. Brown

8 Responses to “They Say This Is Reckless. Yeah, Right.”

  1. David Ray @ 1:40 pm:

    Of course brokers or financial advisors would take take this approach.

    In the case of a broker, they make a commission on both.

    For the financial advisor, they come with “reputations” or “credentials” and their advice is construed as correct, whether it is or not. When selling you on their services, they talk about conservative, sound investing, which is stock or mutual funds. To talk about “risky” options would make them appear to a worse choice than others.

    Dave

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  2. mark @ 1:46 pm:

    whichever scenario one is comfortable trading with is the “responsible” one…that’s why many trader’s lose money…they take on “uncomfortable” strategies/systems, which only brings the emotional aspect into trading!!!

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  3. RichE @ 2:36 pm:

    In my opinion only the native knows the risk of walking through the jungle at night. Don’t ask a broker ask a “successful” trader.

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  4. LimaSierra @ 5:31 pm:

    AJ, you are 100% correct about the risk of a single trade being exactly equal for both strategies, for any amount of movement in the stock price, during any given period of time.

    I think that what makes the real difference between these strategies is that, in the long run, you have a lot less capital tied up in buying Call Options to control the same number of shares of stock, than in buying the Stock plus the protective Put. Therefore, you can have a larger and more diverse portfolio for any given amount of capital, which can reduce your total portfolio risk (what really matters, long term). Beyond that, for any single stock that increases as anticipated, your percentage return is likely to be greater on the Call Option, than on the Stock plus Protective Put. The reason for that is due to the smaller amount of invested capital, even though the option value typically does not increase by the same amount as the stock increases.

    For example, ignoring the Protective Put for the moment, if you buy 100 shares of a $20 stock (a relatively cheap stock) for $2000, and it promptly goes up by $1, then you gain 5% or $100 in the Stock’s value. If you also bought the Protective Put for $2, or $200 to protect 100 shares, then you still have a negative return (or loss) of $100. That is to say that you are still negative by $100 out of $2200 invested, or by about -4.5%.

    However, if you bought the Call Option for $2 ($200 for one option covering 100 shares), and the $1 stock increase causes the option price to increase by $0.50, then you have a 25% return on your investment, or $50 of gain. That is the power of the higher leverage with the Call option. Furthermore, your risk, if the stock should decline, is precisely limited to what you paid originally for the Call Option, and nothing more that the $2 per share. That risk also is something that you can control completely; simply buy or don’t buy the Call Option at its current price.

    However, if the stock declines sharply, you can lose more dollars than the Call price, by using the buy Stock and buy a Protective Put strategy. The reason is that the Protective Put has something rather like an insurance deductible, but on a sliding scale. Let’s say, just for example of how it works, that the Put will give you back $0.50 for the first dollar of decrease in the stock price, due to the increase in the value of the Put that you own. For the second dollar of Stock decrease, you may get $0.60 reimbursement from the increased value of your Put; and for the third dollar of Stock decrease, perhaps you get back $0.70 of Put increase. Eventually, the Put will reach a point where its value increases by $1 for every $1 of decrease in the Stock price. I think you can see that the firm loss limit of $2 that you paid for the Call Option is better protection than the sliding scale of the Put, whose exact amount is not guaranteed and also can vary with market conditions. The other possibility is to purchase a different Put Option, one that gives you more protection sooner (like an insurance policy with a lower deductible). However, you will pay a lot more for that Put, than for a Put with the “larger deductible”; and so that will reduce your gain more if the Stock goes up as expected. There is simply no “free lunch” here.

    One might say: “But I could exercise the Put to sell the Stock at the strike price.” Yes, you could. Just consider that then you will lose the stock, and you will probably not buy it back at the bottom, when it is ready to go up instead of down. That fact may be just perfect for your intentions; or maybe not. That way you will have 100% protection from the time that the Stock declines to the strike price of the Put; the amount of any decline before the strike price is reached will still be a loss for you. If this is more than a few dollars, it could be greater than the price of the Call Option. So, the Protective Put that you will want to use, the one that will protect the full price that you paid for the Stock in case of a Stock decline, will also be a more expensive insurance policy, and may be too expensive for its purchase to be feasible.

    The caution side of leverage is that it can work either for you, or against you. So, for starters and just as a rule of thumb, don’t over-leverage yourself, by buying Options that control more shares of Stock than what you would be willing to hold on to while the Stock *declines* in value.

    Also, you will need to understand a more complicated financial instrument (Options) in order to know what you are really doing with the Call option (or with the Put Option, for that matter). Due to the inherent complexity and flexibility of Options, there are many more traps that can snare the un-informed.

    Plus, there is a whole menu of options available for purchase at various prices and expiration dates. Choosing the wrong Call Option for your intended purpose can produce a loss rather than a gain, even if the associated stock moves in the direction that you desire. Choosing the wrong Protective Put to buy, will either give you less protection at a lower cost, or a higher cost than is necessary for your protection needs.

    Finally, an option is a decaying instrument. So, (1) you need to understand how options decay, and how to measure the expected decay in advance of your option purchase, and (2) the stock needs to make the move that you expect more or less when you expect it. If your timing is off by a month or two, and you have chosen an option that expires in the meantime, you will very likely have a loss, not a gain, for that trade. With the Protective Put strategy, consider that you will need to buy a new Put to remain protected after the old Put’s expiration date.

    In summary, owning the stock gives you the luxury of time, in return for a 10 times larger (typically) investment that will be at risk, an increased risk of a larger dollar loss on a decline, and with less percentage gain for any increase in the Stock price.

    Buying the Stock and the Put will give your Broker a larger commission check, regardless of whether he (or she) is discount or full service, as long as he is on commission. So, go figure why Brokers mostly prefer the Stock plus Put strategy.

    In addition, if you continue to buy that Protective Put while you own the stock, then (effectively) you will be paying out for every day that you own the Put (due to the decaying value of the Put with the passage of time). So the luxury of time comes for a price, if you also have protection.

    Of course, you could reverse things somewhat by owning the Stock and selling a Call Option against the stock you own, instead of paying for the Put Option. But that is another whole story with its own risks and traps. Before you actually try that strategy, just consider that your maximum potential loss occurs if the Stock goes to a value of zero dollars, and your loss is then equal to the price you paid for the stock, minus the income you obtained from selling the Call Option. Of course, that risk of loss is only little less than the risk of loss you assume by owning an unprotected stock at any time. So maybe you are used to it.

    I have tried to give a fairly complete, brief balanced summary of the major factors affecting both the “Buy a Call”, and the “Buy the Stock plus a Protective Put” strategies. I hope that might help some of the less experienced readers. For you “old pros”, I realize that this discussion only contains things that you already knew.

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  5. Dirk @ 6:07 pm:

    I joint trading trainer a few weeks ago and am still a newby. I do not understand the advantage of buying the stock at expiration date of the option.
    If the option’s time value goes down and the stock price does not increase,or even decreases,then I would buy the stock for the strike price, which is higher what the stock is worth at expiration of the option and I would loose money again,or am I totally wrong here???
    Please give me some help in this!!
    Dirk

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  6. Zero G @ 3:30 pm:

    Who’s that other guy in the picture?

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  7. LimaSierra @ 3:44 pm:

    Dirk,

    Usually you are better off to sell the option you own, the one that would allow you to buy the stock, than to exercise it and actually own the stock. You will have to put up a lot of money to actually buy the stock - the option strike price x the number of option contracts exercised x 100 shares per contract (usually). Plus you will be giving up whatever value your option had, right before you exercised it.

    The exception would be if you wanted to capture a dividend or stock split that will only be paid or given to actual stock holders. Then you might want to own the stock. However, the normal dividends for the stock are figured right into the market value of the option to buy that stock, if a dividend payment date falls within the life of the option. So you seldom gain much by actually owning the stock, unless you plan to hold the stock for a longer time period, since of course the stock has no expiration date.

    Also, the only time you would want to exercise your option to buy the stock would be when the market price of the stock is greater than the strike price of the option plus the market value of that option. Otherwise, you could own the stock for less money by selling the option for whatever it is worth in the options market, and buying the stock yourself on the open stock market.

    Remember that, as the owner of a stock Call option, you have the right, but not the obligation, to buy the stock at a fixed price up to the expiration date of the option contract. You would only exercise that right when it is in your best interest to do so. There is never any requirement that you must buy the stock, at least not in American option contracts.

    If you have an “In the Money” Call option in your brokerage account, and the stock is worth more than the strike price of the option by some amount (like $0.05 per share typically), then your broker should exercise the option for you automatically at option expiration, so that you don’t lose the $0.05 or more per share, through the expiration of the option. You had better have enough money in your account to pay for the stock, or else your broker will immediately sell the stock for you at the market price the next trading day, which could even be at a loss to you. You can always tell your broker in advance not to exercise a particular option at its expiration.

    However, usually one simply sells the option before its expiration date, so that automatic exercise is not an issue for you. That way some professional market maker deals with the details of possibly exercising the option at its expiration.

    That it a lot of detail. I hope it helps to answer your questions.

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  8. Albert Hotwagner @ 12:19 pm:

    Hi A.J. Id like to be informed when you trade and what stocks you pick. What do I have to do to grab onto your tails and be A successful trader. Al

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