Last weekend, I posed a number of questions for your review. The
first question asked that you rate a number of strategies from least
risky to riskiest and the second asked whether there is any zero risk
trade. These questions were designed so that you could perform your own
test of risk awareness. I have asked these same questions in a number
of seminars I have given in the past and one mis-perception is a
relative constant.
Many investors and traders who are relatively inexperienced in the
markets tend to look at the strategy of buying stock as relatively low
risk. Brokers allow almost all clients who have enough money in their
accounts to buy stock. Buying stock, however, is quite risky. The risk
is the cost of the stock. Something you buy at $25 or $50 or $150 a
share can go to zero. If you don't believe it, ask people who owned
Worldcom or Enron. While it may be rare that a stock actually goes to
zero, it is definitely not so rare that they drop in price. Many things
like competition, new products, lawsuits, executives leaving, etc. affect
stock prices and when a stock you own goes down in price, you lose a
dollar for every dollar down.
Buying a stock and writing a covered call has a little less risk
than just buying a stock. In that strategy, your risk that the stock
price can fall to zero remains, but when you sell a covered call, the
market pays you a premium to take on the obligation to sell your stock
if it is assigned. The money that comes in as payment of the premium
then reduces the overall risk in the position. Suppose you bought some
ABC shares for $20; your risk would be $20. Now suppose that you bought
the stock for $20 and also sold the next month out $20 calls for $1.50.
Now your net cost (before commission) would be $20 - $1.50 = $18.50. As
you can see, that risk is less than simply owning the stock. Of course,
if the stock price jumps to $30 you can still be called out for $20 so
you would lose the "opportunity" to make the extra $10 per share, but
you would still have gotten the $1.50.
Though brokers may tell you that selling naked puts is very
dangerous, the strategy has precisely the same risk graph as writing
covered calls. When someone writes (sells) a naked put, he is being
paid a premium to buy stock at a certain price (the strike price) at any
time until the option expires. If we look at the same example of ABC
trading at $20, we could sell the one month expiration at a $20 strike
for $1.50. The market is paying us $1.50 a share to take on the
obligation to buy the stock at $20 a share if it is put to us. If the
stock is trading for more than $20, no one would put it to you since
they could get more by selling it on the open market. If the stock is
put to us, we have to pay $20 a share so the risk is the same as if we
bought at $20 in the first place. However, the market paid a $1.50 a
share premium to us when we sold the naked puts so the risk, once again,
would be the stock price ($20) - premium received ($1.50) or $18.50.
Selling naked calls, on the other hand, may be one of the riskiest
of all strategies. The theoretical risk is limitless if one sells a
naked call. The seller of a call takes on the obligation to sell the
stock at the strike price anytime up to expiration. If the call is sold
naked, that means that the trader does not own the stock. If he sold
the $30 calls when the stock was trading at $28 and took in a $1.25
premium, he would have no concern until the stock got above $30. What
if the company announced some fantastic news and the stock shot to $50 a
share. Now, at or before the calls expired, he would be assigned
(called) and he would have to sell the stock at $30, but he has no stock
so he would have to go buy it first. But the price is now up to $50 so
he has to buy at $50 and sell at $30. That scenario is not too
pleasing. What if the stock ran to $100? Same problem, only worse. Now
he would have to buy at $100 to fulfill his obligation to sell at $30.
Yes, there can be a zero risk trade. Do you know what it is called
or how to create it?
Good Trading!
Bill Kraft
Mr. Kraft's past articles are posted on our website for your review.
