A common way for stock investors to reduce investment risk is with options. Options trading provides a way for investors to leverage their capital and hedge risk at the same time. Here we look at the use of calls and puts to reduce investment risk with options contracts.

What Are Call and Put Options?

A call option gives the buyer the right to purchase a stock at a set price called the strike price no matter how high that price might climb. Because it is an option the investor is under no obligation to execute the contract unless doing so is advantageous. A put option gives the buyer the right to sell a stock at the strike price no matter how far the stock price might fall. And the investor is under not option to execute the contract unless doing so is advantageous.

How Can I Reduce Investment Risk with Call Options?

Let us say that you have been following the fortunes of a company in trouble, ABC Corp. You would think that the stock of ABC Corp. is going to go up. It is currently selling at only $10 a share but you believe that it will become a takeover target and that the price may well double or triple along the way. The problem that you see is that if the company does not obtain capital in a merger or takeover that it may well go bankrupt and if that happens the price will fall to $0 a share. A way to reduce investment risk with options in this case is to purchase calls on ABC Corp. In doing so you will limit your risk to the premium paid for the call option, which we will say is $1 a share. So you purchase a $115 call contract for 100 shares of ABC Corp. for $100. This means that you will pay $115 a share for the stock up until the expiration date. The takeover may not happen and the company may go bankrupt in which case you will lose your $100. But this would be better than if you had purchased the stock, as you would have paid $1000 and lost all of it. If, in fact, the stock triples in price to $30 a share you will execute the contract and pay $15 a share or $1500 for 100 shares that are really worth $3000.

How Can I Reduce Investment Risk with Put Options?

In this case let us assume that you invested early in a biotech startup, XYZ Genetics. You bought it at $1 a share and now its all-star drug has passed stage II FDA trials and the stock is selling for $100 a share. You are very happy but you are also concerned that the drug in question may not pass the final FDA hurdles and that the stock price will fall dramatically. But, you do not want to sell the stock because, if it passes the final hurdles, it will probably spit and split again making your original $1 a share worth $400 a share. So, how do put options help in this case. What you do is buy puts on the stock that you own so that if the stock price falls you will still sell at the current stock price and not take a loss. The price that you will pay for this insurance is the premium for the put option. As these hypothetical examples show, stock option trading can be used to hedge investment risk.

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