I often advise readers to gravitate toward options to limit risk during periods of particularly tumultuous market action, explains Todd Salomone, technical expert at Schaeffer's Investment Research and editor of Money Morning Outlook.
And I recommend options as a risk-management tool in all sorts of environments -- whether the choppiness in stocks is due to the collision of major support and resistance levels for the benchmark equity indexes, a particularly fraught geopolitical backdrop, high-stakes macro uncertainties (such as a looming Fed decision), or even just periodic presidential tweetstorms.
This advice might surprise some readers, given that options trading is so often associated with aggressive, "swing for the fences" type bets on big directional moves. But there are three simple ways that options limit your risk (while letting your profits run!) in even the wildest, most unpredictable market environments:
1. Your dollars at risk are clearly defined and limited.
When buying options, the cost to purchase one options contract (representing the right to buy a fixed number of shares, typically 100, of the underlying security at a set price by a set date) is far lower than purchasing that same number of shares outright.
And even if you wind up dead wrong on the trade, the maximum amount you can lose is that initial dollar amount you put up to buy the option.
So not only are you putting less capital at risk, you're also curbing how much you can potentially lose on that single trade. By contrast, strategies such as selling a stock short leave the door open to potentially steep (and theoretically unlimited!) losses on an adverse move.
2. You stand to make profits many times greater than your dollars at risk.
The reduced cost of entry on options, as described above, also allows option buyers to reap profits that represent a multiple of their initial investment — and often, many times greater than shareholders in the same security, who may be collecting single- or double-digit percentage gains while options holders rack up triple-digit gains.
This feature is known as "leverage," and it means that options traders can fully participate in and profit from directional moves in stocks while simultaneously keeping their dollars at risk to a minimum.
Normally, when you put fewer dollars at risk, you can expect fewer dollars in return. However, given that option buying provides an opportunity to make a multiple of your investment (since, per above, the purchase of one contract controls 100 shares of the underlying), traders can reap similar dollar profits to stock buyers or those shorting the stock, even with much less capital at risk.
And in many cases, when stock buyers do reap triple-digit percentage gains on their investments, it can take months or years to build those outsized returns -- whereas in an option-buying strategy, leverage allows you to rack up those big percentage wins in days or weeks.
3. Make money in up or down markets.
The low upfront cost of options makes them a great way to add directional diversity to your portfolio. Not only can you use calls to profit during bull runs and puts to make money during bear markets, but you can also play directionally neutral strategies like straddles, which capitalize on increased volatility in the underlying stock -- regardless of whether it shoots higher or lower.
Plus, even if stocks are moving sideways, there are options strategies (such as credit spreads) specifically designed to generate steady income from this type of traditionally "unrewarding" price action.
So while buy-and-hold stock investors might find themselves frustrated with a flat-lining market, options traders can still watch their bottom lines grow.
So, by shifting some of your investing capital toward options strategies during times of turmoil, you can effectively reduce your dollars at risk, while still maintaining participation in the market -- allowing you to navigate periods of heightened volatility exactly like the pros.
One stock where I'm playing the upside with limited dollars at risk is Hershey (HSY), which recently hit its most oversold reading since December 2018.
The pullback was contained by the 60-day moving average -- a trendline that's off the radar of many traders, but which roughly coincides with the round $150 area and is so far providing a springboard for the stock.
This HSY bounce could be aided by short covering, in our view. Shorts have already been in covering mode for months, but the equity still boasts a short interest ratio of 3.5 days to cover.
Upgrades could draw more buyers to the shares, too, as only two brokerage firms out of 12 currently rate Hershey a "buy" -- despite its market-beating gain of more than 40% year-to-date.
To play a continued HSY uptrend, I just picked up two-month calls that are about 5 points in the money. One of these calls affording control of 100 shares is currently asked at around $10.50, and will achieve a 100% profit on just a 10% rise in Hershey stock from current levels.
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