Limited Risk in Options
Buying options offers unlimited profit potential for a limited risk. When buying options your total risk is the amount you pay for the option plus brokerage. You cannot lose any more than what you paid for the option no matter how far the market goes against you.
High leverage and limited risk is what attracts the majority of option buyers. This is different to the risk profile of futures, which have potentially unlimited risk associated with them (although stop losses can be used to help limit risk).
The Benefits of Limited Risk
The major benefit of having limited risk is that it gives you the ability to stick with a trade no matter how far the market goes against you, or how volatile the market becomes. There is no margin to pay like in futures and you cannot be stopped out of your position on a minor correction.
You can hold your position in the market knowing that your maximum loss can be no more than what you paid for the option. You can then wait patiently for the market to resume moving in your favour once again.
Options that are purchased with an exercise price reasonably near to where the market is currently trading have a greater probability of becoming profitable. This is because the market does not need to move in your favour as far for you to make a profit. The downside is that because they do have a better chance of being profitable these options will cost more to buy.
Let’s now look at an example of buying a call option to see how this principle of limited risk applies in the commodity markets.
Example: Buying a Gold Call Option
You have a view that the price of gold will rise to $400 over the next few months. You don’t wish to risk too much money in case your forecast is wrong. Gold is currently trading at $280 per ounce. (Please note that all figures are in US Dollars and exclude brokerage)
Strategy – Buy 1 February gold call option with an exercise price of $300
- Premium (cost) of option is $200
- Every $1 increase in the price of gold above the exercise price ($300) at expiry is equal to $100 in profit.
- Your breakeven point will therefore be at $302 at expiry to make up for the cost of purchasing the option ($200).
The limited risk in this example is the $200, which is the premium (cost) of the option. February refers to the month of expiry of the option. The $300 is the exercise price, (price that the buyer of the option has the right to buy gold at if he wishes to exercise his right).
If the price of gold finishes below $300 when the option expires (February) it will have no value and the amount lost will be the $200 initially paid for the option.
The unlimited profit potential in this example refers to the possibility of the price of gold moving above $302 before or at the expiry of the option. Every $1 increase above $302 (our breakeven point) will be an extra $100 in profit. The higher the price above $302 the more profit you will earn.
…Three Months Later
Your forecast is correct. The current price of gold at the expiry of the option is $400. The call option you originally bought for $200 is now worth $10,000.
How did I come to this figure? I simply took the current price of gold (in this example $400), took away the exercise price ($300) and multiplied it by $100.
Less the premium paid for the option ($200), this would leave a profit of $9,800 per option contract.
When you consider that in 1980 gold made a high of $875, you can see why people are attracted to the commodity markets by the leverage offered by options.
Can I Sell my Option Before Expiry?
Of course you do not have to hold the option to its expiry date. At any time you can sell your option in the market to lock in a profit or a loss.
How much your option will be worth will be a function of the amount of time remaining in the life of the option (the more time to expiry, the more the option will be worth), the current price of the underlying commodity, and how volatile the underlying market is (the more volatile, the higher will be the price of the option).
Use the limited risk advantage gained by buying options when option volatility is low (see principle two) and the technical pattern or trend of the market suggest a large move is likely to occur.
A Real Life Example
Let’s look at an example of a trade that I recommended to my clients in November 1999 that benefited from the limited risk advantage of options.
In the trade in Figure 1, I recommended buying a March Light Crude Oil Call Option with an exercise price of $26.00 (a). The premium paid for this option was US$1, 190.
After initially rallying, crude oil pulled back in late November and again in the first week of January, before re-establishing its upward trend.
By buying a long-dated option my clients were able to stick with the trade through what in hindsight was a temporary correction, and sell in late January (b) for $USD 2,350. Had we used futures instead of options we would most likely have been stopped out of the trade and subsequently missed out on a good part of the move.
Take advantage of medium to long-term trends in the market by buying options with three or more months left to expiry. If you are not prepared to risk the whole amount paid for the option, then set exit points either at a pre-determined price level or alternatively if the option loses half its value.
If you have ever traded futures you will know how frustrating it can be to have correctly picked the direction of the market, only to see it briefly turn around and take out your stop loss, before continuing in the original direction once again, this time without you in the trade. Trading options can help you to avoid this situation.
You never know when a good move will take place. There are indicators that can help you, but most of the time what is needed is patience. This means giving your trade the appropriate amount of time to work in your favour.
Limited Risk in Volatile Markets
The limited risk characteristics of buying options are also particularly useful in trading volatile markets, which have the potential for explosive moves and large profits.
Many of these markets you would probably not even consider trading futures with because of high margin costs as well as the high probability of being stopped out on a normal market fluctuation. Buying options however gives you staying power without the unlimited risk associated with futures.
The extreme volatility exhibited in the Coffee market in October 1999 (refer to Figure 2) meant that using futures to profit from the upward trend that began in October would have been very expensive due to the high margin requirements at the time. The potential rewards however are very attractive, a move from the low of 80 to the high 140 for one contract would be worth US$22,500.
The probability of being stopped out of a move like this if you were trading futures would be high. The wider the stop, the higher the risk you would need to be prepared to take in order to stay in the trade.
Holding long-dated options on the other hand would have allowed you to stay in the trade despite the volatility, without incurring any additional risk above what you paid for the option.
Buy ‘cheap’ options with an exercise price a long way from the current market price and with limited time to expiry only if you expect a sharp immediate rally or decline to occur. If the move does take place as expected these options offer the greatest leverage. If not, then be prepared to lose the majority of the premium. In options as well as in life, you get what you pay for.
Limited Risk Summary
- Buying put and call options gives you unlimited profit potential with limited risk.
- Buying options offers you high leverage with limited risk.
- Buying options with ample time left to expiry gives you the ability to stick with a trade through a minor correction with limited risk to take advantage of a longer-term trend in the market.
- Buying options incurs no margin.
- At any time up to the expiry of the option that you bought you can sell the option in the market to exit the trade.
- Buying options in potentially volatile markets, eg currency markets, can provide the potential for large gains with limited risk.