Shares Stock Index

Companies like Enron and Worldcom were once considered "high flyers," solid reputable companies, and good investments. If you were invested in such stocks after early 2000, you likely lost much, if not all, of your investment. A stock investor is always at risk of losing significant amounts of capital. Diversification can help offset some of the risk, but even diversified mutual fund holdings were not immune from market declines in 2000-2002. A traditional stock investor can only protect their holdings by divesting themselves of their investments. In other words, a stock investor must sell some or all of her stock portfolio to reduce market risk. The stock market is a risky game if you do not know how to protect yourself against potential losses. Fundamental and technical analysis have their limitations and while stop loss orders can be used to exit positions that decline in value, they cannot guarantee an exit point. USING OPTIONS USED TO REDUCE MARKET RISK Stock options are either "call" options or "put" options. A "call" option is a standardized contractual agreement that gives the buyer of the option the right to buy 100 shares of stock at a specified "strike" price on or before a specified "expiration" date.

If you believe that a company's stock is poised to appreciate and it is currently trading at $30.00 per share, you can purchase 100 shares of the stock for $3,000.00. Your maximum risk on the trade is $3,000 and your upside potential is unlimited. Alternatively, you could purchase a call option for a fraction of what the underlying stock might cost. As the owner of a call option you would have the right to buy the underlying stock at a pre-defined "strike" price. Instead of paying $30 per share, you might only pay $2.00, perhaps a little more or a little less, for a call option with an "at-the-money" strike, i.e., $30 per share. Let us assume that the stock behaves as we expect and it appreciates to $40 per share in price. If you had bought the stock, you could now sell it and realize a $10 per share profit. This represents a gain of 33% on the capital invested, which is a very good return.

Perhaps you do not know whether a stock will move up or down, but you do believe it is likely to make a significant move in one direction or another. A stock trader is at a loss, because she does not know whether to buy stock or sell it short. As an option trader, it is possible to profit by using an option strategy such as a straddle. A straddle involves the simultaneous purchase of both a call and a put option. Assume your stock is trading at $30 per share and you expect that it will make a large move, but you are not sure whether it will be an upward or downward move. You decide to buy a call and a put for a combined price of $3.50 per share. If the stock makes a large move to the upside, your call will gain value and your put will lose value. If the stock moves to the downside, your put will gain value but your call will lose value. Because maximum loss is limited on both the call and the put, there is a finite value by which either can decline while providing unlimited profitability on the other side. If the stock makes a large upside move to $45, your call will be worth a minimum of $15 per share. You paid $3.50 for the combined put and call, so your minimum profit would be $11.50 or a return of approximately 329%. In the event of a large downside move to $20 per share, the put would have a minimum value of $10which would produce a minimum profit of $6.50 per share or a return of 186%. These returns are possible while risking no more on the trade than that combined amount paid for the call and put option.