Can Any Investment Have Limited Risk, Unlimited Reward…?

falling graph of stock market

Wouldn’t it be great to gain exposure to a share price move without risking a big chunk of your capital? It certainly sounds appealing to me.

It’s one of the key attractions trotted out about options. For just a fraction of the cost of buying shares outright, a trader could instead buy a call option to gain exposure to an upside move in the share price.

By buying an option, you’re buying time to make a decision later. It allows you to put your toe in the water to see whether your trade hypothesis pans out. If the share price moves up, you’ve already locked in your entry price before the move.

It all sounds like a pretty good deal. A few hundred dollars could potentially deliver multiples of that if you get the trade right. Because you only need a small amount of capital to buy options compared to shares, you can make your money work harder.

It’s this leverage that is one of the major attractions of trading options. Options allow you to leverage up your capital to gain a bigger exposure to the underlying shares. If you do get the trade right, this leverage enables you to generate a higher return on equity.

The old ‘risk versus reward’ argument

Buying a call option also has another attraction. It comes with limited risk. All the call option buyer can lose is the premium they pay. If they buy a call option and the share price tanks, they just walk away. The only hiccup is they lose whatever money they paid for the option.

On the face of it, it looks like a much safer deal to buy options than buying the underlying shares. After all, you’re risking much less capital. All shares have the potential to fall to zero. If you buy shares and the price goes off a cliff, you’re left with a much bigger hole in your trading account.

But it’s not just the potential losses that seem to favour options over shares. The rewards also look much more appealing due to something else.

In theory, a share price can go to infinity. Because an option enables you to gain more leverage (and therefore exposure) than buying shares, its potential returns look better on paper than buying shares.

But the problem with that is it’s just theory. Sure, a share price could theoretically go to infinity. But not one share ever has, and, as far as I can foretell, ever will.

That’s why you need to look further than the supposed benefits of buying options. While limited risk and unlimited reward sounds very appealing, it ignores a basic premise of the market.

It’s about probabilities

While share prices could potentially trade anywhere between zero and infinity, there’s a higher probability that they will trade within a range. This range varies on the volatility of the shares.

It’s much more probable that a low volatility stock, trading at $5 for example, could trade in a range between $4.90 and $5.10 than it is to trade at $2 or $8. Sure, it might happen, but it’s much more likely to trade closer to the previous price.

It’s these probabilities you need to consider before buying an option. While those who ‘punt’ options think about possibilities — that is, how much they could make if the share price rockets — the professionals think in terms of probabilities.

Sure, a share price could go through the roof, but what is the probability that could happen? Remember that options are only traded on the top 60–70 stocks. What’s the likelihood that the share price on the largest stocks on the ASX could spike to infinity before the option expires?

And what is the probability that the share price of Telstra, Woolworths, or one of the banks, goes to zero? While buying an option (instead of buying shares) might negate this risk, it would seem to be an unlikely event. It could potentially happen, but it isn’t highly probable.

That’s why professional market-makers take the other side of the trade. They’re looking to profit by selling options to traders who punt on an unlikely event. They profit from share prices trading within a range, not speculating on what might happen. It’s what we look to do at my advisory service, Options Trader.

While buying options might be touted as limiting risk, it can be the other way round. Every option you buy that lapses without being exercised, eats another piece of your capital. Do this over and over and your capital quickly evaporates. A supposed ‘limited risk’ trade can still lead to significant losses if you continue to buy options to speculate on improbable events.

Most of the options traded have expiries less than three months away. It’s a constant battle against time which erodes the value of the option day after day. While buying an option does have limited risk and unlimited potential in theory, you need to think about the probability of what share prices will do.

Regards,

Matt Hibbard,
Editor, Options Trader

From the Port Phillip Publishing Library

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Matt Hibbard

Matt Hibbard

Editor at Total Income

With nearly three decades in the markets, Matt has traded just about every asset class there is. The one thing that has stuck with him over this time is a very simple premise. That is, it’s the cash a company generates that ultimately determines its value.

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