Have you ever noticed the largest buildings seem to always belong to banks or insurance companies? Ever wonder why? It is simple really. Banks and insurance companies are in the business of managing risk, and that leads to profitability. If that sounds like a boring business it might be one you should consider if you want to also be living in a big building of your own.
If we break it down to the most basic principle it is fair to say almost all financial instruments are designed as a way to manage risk. Better said, they are designed to off load risk to a speculator.
Let’s take for example a futures contract–it is designed to off load risk from a commodities provider (say a cattle farmer or a meat processor) and allow them to manage their costs of business. On a more complicated level credit default swaps and mortgage backed securities– those evil words we hear about from the 2008 financial crisis –these instruments were also created to offload risk. And, of course, public stock issues in and of themselves are a way to offload investment risk from a large financier and diversify it over many smaller capital contributors.
The option contract is one such risk management tools available for individual traders to work with. Just in case you are not familiar with options let me offer a quick overview. I’m going to define these in terms of the stock market but they can apply to futures or forex just the same.
There are two types of options:
Call Option – The call option gives the buyer the right to buy a stock at a certain price.
Put Option – The put option gives the buyer the right to sell a stock at a certain price.
Can you see how these options would be beneficial for you?
Imagine you are in a short trade and the market suddenly turns up against you. What would you like to do? If you are like everyone else you are thinking “Oh, if only I could go back in time and buy to cover my position.” The call option gives you that right–the right to buy a stock at a certain price.
Or, imagine you just loaded up on your favorite index ETF and suddenly 2008 happens again and the whole market collapses. Now you are thinking “Oh, if only I could go back in time and sell.” The put option gives you that right.
IT’S LIKE INSURANCE
The call and the put option can be used as an insurance policy for the trader. As a trader you can see the benefit – it offloads risk. Just like you buy a car policy to protect your new Porsche from that 16 year old driving his (or her) beat up Volkswagen Bug, the call and put options can protect the equity investor from an unseen action by the Federal Reserve, or the president, or a terrorist, or a flash crash, or…. You get the idea.
I personally feel every investor, whether they are in it for the short term or the long term, needs to understand the power of options. They are the primary tool available to the individual to off-load risk from a position. Sure stops are great – but they don’t provide protection they simply provide an exit point. An insurance policy provides “protection.” They allow the investor to manage risk – just like banks and insurance companies. Investors who manage risk well can expect to one day have that big building of their own!