Hi Wayne
I am looking to structure my trades so as to have a low exposure to the risk. I would like to ask what is wrong with working with this type of structure. I understand it at least..lol.
Buy 1000 XYZ for $12.00 a share......................cost 12,000
Buy 1 12.50 put option for $1 a share ......................1,000
Total cost ..........................................................13,000
If stock goes against you and goes down potential max loss 3.84%
sell stock 12500
outlay 13000
-500
You can also write a covered call but bit tired to work it all out now.
Why is this type of set up so risky as you have indicated in the past.
Cheers
SG
Hi SG,
It's not that it's risky. You have limited your absolute downside risk to $500, that's fine.
But, you are trading other risks for removing that downside risk. You are paying someone else to take them on for you.
If those other risks are acceptable in exchange for limiting downside risk, you go ahead and put the trade on. If not, then don't trade.
Let's have a look:
* Your put option is 50c in the money. That means that *at expiry* you will incur maximum loss at any price up to $12.50 and you won't break even until $13.00. That means your stock could rise a full 8% and you still make a loss after costs.
* You are slightly increasing your contest risk, capital needed and carrying costs. Contest risk is brokerage and spread and you are adding at least one extra commission. You are using $13k for a $12k position and you are carrying that $13k position (loss of risk free bank interest received on cash).
OK here's a couple of things to think about:
* Always consider synthetically equivalent positions. What you in fact have in the above, is a synthetic $12.50 call option which you can buy for ~$600. If you like the above risk profile (the stock plus long put), you can achieve the exact same risk profile (once cost of carry on long stock is considered) with the long call.
* You are using much less capital, contest risk may be less (but certainly not more), and you are achieving exactly the same thing.
* Consider other strikes and expiries, think about which trade offs are best for you.
* There are other considerations, buts that's enough to think about for now.
Options are all about compromise, you are swapping one type of risk for another. That's good, because you get to choose which set of risks are most palatable to what you are trying to achieve.
Cheers