Using Options to Reduce Risk

Many people have never considered using options to reduce risk because they have been told options are dangerous or risky.

Like most financial advice, take a look at the source before you believe it hook, line and sinker. Unless your source retired thanks to his stock portfolio before the age of thirty then stop believing everything you hear and begin thinking for yourself.

Put options are one method of minimizing your exposure to risk - particularly if you are holding significant equity in only a few stocks (if that is you, then be sure to read our tips on diversification to reduce debt). By putting all of your eggs - or stocks - in one basket, you are opening yourself up for heavy potential losses should a problem arise.

The biggest culprits are usually employees who believe their company is rock solid - take a moment to think this through. First of all, a lot of Enron employees thought the same thing but where are they today? Next, you are at double exposure to risk - the loss of your job combined with the loss of your investment portfolio!

So, ready to hear how those put options work in real life? It's simple really...a put option requires you to pay an up-front premium for the "option" of selling your stock at a specific price within some period of time. See our Learn Options trading page for more... Let's assume you work for company XYZ and have invested heavily in the purchase of company stock. You don't want to take a heavy tax hit by selling your stock this year, so you aren't quite prepared to take the good advice to diversify in order to reduce your risk but you are not completely without prudence, and decide to explore the use of put options instead. Good decision.

Let's assume XYZ is selling for $35 per share and you want the ability to sell at $30 a share for the next year at which point you will be in a better position to diversify your portfolio. For now, you decide to pay $2 a share to buy a "put option". The $30 per share is called your "strike price". If the stocks go up - great! Do nothing. If the stock drops like lead (or Enron) then your put option allows you to sell your shares for $30 each no matter how low they go on the market.

Book: Create Your Own Hedge Fund: Increase Profits and Reduce Risk with ETFs and Options

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