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Is there a good options strategy that has a fairly low risk? It doesn't matter if it's complicated, has several legs, and requires margin.

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5 Answers 5

Check out this site:

http://www.m-x.ca/produits_options_actions_en.php (Under the Trading Strategies).

If you have a background in math or eco or are comfortable with graphs, I suggest you graph the payoffs of each of these strategies. It will really help you understand it. If you need help with this, let me know and I can draw a couple out for you.

Your question is rather vague but also complicated however I will try to answer it. First off, many investors buy options to hedge against a current position in a stock (already own the stock). But you can also try to make money off of options rather than protecting yourself.

Let's suppose you anticipate that a stock will increase in value so you want to capitalize on this. Suppose further that you have a small amount of money to invest, say $100. Suppose the stock is currently at $100 so that you can only afford 1 share. Suppose there is a call option out there with strike $105 that costs you only $1.

Let's compare two scenarios:

  1. Buy 1 share of the stock ($100)
  2. Buy (aka going long) 100 call options ($100).

The stock increases to $120 at the maturity date of the option.

  1. You have made $20
  2. You have made ($120 - $105) x 100 = $15 x 100 = $1,500

So, you made a lot more money with the same initial investment. The amount of money you put in is small (i.e. can be perceived as low risk). However, if the stock price ended up being $104.90 then your options are worthless (i.e. can be perceived as high risk).

HTH.

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Holding cash equal to the underlying's notional value, plus buying an at-the-money call option, is economically equivalent to buying a put to hedge a current position in a stock. In both cases the option cost is going to eat up your returns, on average. You can't just buy the upside on stocks without taking any downside, it costs money to buy the upside and the money it costs on average is "a lot" (enough to eat up your upside on average). –  Havoc P Oct 3 '11 at 3:40
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No. The more legs you add onto your trade, the more commissions you will pay entering and exiting the trade and the more opportunity for slippage. So lets head the other direction.

Can we make a simple, risk-free option trade, with as few legs as possible?

The (not really) surprising answer is "yes", but there is no free lunch, as you will see.

According to financial theory any riskless position will earn the risk free rate, which right now is almost nothing, nada, 0%.

Let's test this out with a little example.

In theory, a riskless position can be constructed from buying a stock, selling a call option, and buying a put option. This combination should earn the risk free rate. Selling the call option means you get money now but agree to let someone else have the stock at an agreed contract price if the price goes up. Buying the put option means you pay money now but can sell the stock to someone at a pre-agreed contract price if you want to do so, which would only be when the price declines below the contract price.

To start our risk free trade, buy Google stock, GOOG, at the Oct 3 Close:

495.52 x 100sh = $49,552

The example has 100 shares for compatibility with the options contracts which require 100 share blocks.

we will sell a call and buy a put @ contract price of $500 for Jan 19,2013.

Therefore we will receive $50,000 for certain on Jan 19,2013, unless the options clearing system fails, because of say, global financial collapse, or war with Aztec spacecraft.

According to google finance, if we had sold a call today at the close we would receive the bid, which is 89.00/share, or $8,900 total. And if we had bought a put today at the close we would pay the ask, which is 91.90/share, or $9190 total.

So, to receive $50,000 for certain on Jan 19,2013 we could pay $49,552 for the GOOG stock, minus $8,900 for the money we received selling the call option, plus a payment of $9190 for the put option we need to protect the value. The total is $49,842.

If we pay $49,842 today, plus execute the option strategy shown, we would have $50,000 on Jan 19,2013. This is a profit of $158, the options commissions are going to be around $20-$30, so in total the profit is around $120 after commissions.

On the other hand, ~$50,000 in a bank CD for 12 months at 1.1% will yield $550 in similarly risk-free interest.

Given that it is difficult to actually make these trades simultaneously, in practice, with the prices jumping all around, I would say if you really want a low risk option trade then a bank CD looks like the safer bet.

This isn't to say you can't find another combination of stock and contract price that does better than a bank CD -- but I doubt it will ever be better by very much and still difficult to monitor and align the trades in practice.

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Paul, I like the way you explain the trade. However, I believe this is not as risk free as it seems. One possible outcome is that Google goes to up to 505 a few days later, and your stocks get call. You still own the put option, which if it goes to 495 it will cost you a lot to get out, and you will probably want to sell it back after. –  Geo Sep 30 '12 at 0:01
    
@Geo If the stock price goes to 495, or even $0.01, the long put option will provide a fixed price sale of 500. –  Paul Sep 30 '12 at 0:40
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You may look into covered calls. In short, selling the option instead of buying it ... playing the house.

One can do this on the "buying side" too, e.g. let's say you like company XYZ. If you sell the put, and it goes up, you make money. If XYZ goes down by expiration, you still made the money on the put, and now own the stock - the one you like, at a lower price. Now, you can immediately sell calls on XYZ. If it doesn't go up, you make money. If it does goes up, you get called out, and you make even more money (probably selling the call a little above current price, or where it was "put" to you at).

The greatest risk is very large declines, and so one needs to do some research on the company to see if they are decent -- e.g. have good earnings, not over-valued P/E, etc. For larger declines, one has to sell the call further out. Note there are now stocks that have weekly options as well as monthly options. You just have to calculate the rate of return you will get, realizing that underneath the first put, you need enough money available should the stock be "put" to you.

An additional, associated strategy, is starting by selling the put at a higher than current market limit price. Then, over a couple days, generally lowering the limit, if it isn't reached in the stock's fluctuation. I.e. if the stock drops in the next few days, you might sell the put on a dip. Same deal if the stock finally is "put" to you. Then you can start by selling the call at a higher limit price, gradually bringing it down if you aren't successful -- i.e. the stock doesn't reach it on an upswing.

My friend is highly successful with this strategy.

Good luck

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There isn't really a generic options strategy that gives you higher returns with lower risk than an equivalent non-options strategy. There are lots of options strategies that give you about the same returns with the same risk, but most of the time they are a lot more work and less tax-efficient than the non-options strategy.

When I say "generic" I mean there may be strategies that rely on special situations (analysis of market inefficiencies or fundamentals on particular securities) that you could take advantage of, but you'd have to be extremely expert and spend a lot of time. A "generic" strategy would be a thing like "write such-and-such sort of spreads" without reference to the particular security or situation.

As far as strategies that give you about the same risk/return, for example you can use options collars to create about the same effect as a balanced fund (Gateway Fund does this, Bridgeway Balanced does stuff like it I think); but you could also just use a balanced fund. You can use covered calls to make income on your stocks, but you of course lose some of the stock upside. You can use protective puts to protect downside, but they cost so much money that on average you lose money or make very little. You can invest cash plus a call option, which is equivalent to stock plus a protective put, i.e on average again you don't make much money.

Options don't offer any free lunches not found elsewhere. Occasionally they are useful for tax reasons (for example to avoid selling something but avoid risk) or for technical reasons (for example a stock isn't available to short, but you can do something with options).

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micron covered call

By coincidence, I entered this position today. Ignore the stock itself, I am not recommending a particular stock, just looking at a strategy. The covered call.

For this stock trading at $7.47, I am able, by selling an in-the-money call to be out of pocket $5.87/sh, and am obliged to let it go for $7.00 a year from now. A 19% return as long as the stock doesn't drop more than 6% over that time. The chart below shows maximum profit, and my loss starts if the stock trades 21% below current price.

The risk is shifted a bit, but in return, I give up potential higher gains. The guy that paid $1.60 could triple his money if the stocks goes to $12, for example. In a flat market, this strategy can provide relatively high returns compared to holding only stocks.

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