Unless you are an investor who believes in a “buy and hold” strategy, at some point you would be tempted to short the market. If you traded purely stocks, one would short “X” number of shares and hope the market goes down. If you’re a more sophisticated investor (or short term trader), you would use one of the leveraged products like Futures, CFD or Spread DFB which could give you a higher exposure, say 10:1 or even more depending on the number of contracts you choose to short.
So what are your chances you would end you end up making money and at what risk?
The statistical chance of above position making money is just 33%! The position has unlimited risk which means you could even end up losing 50% or more of your capital. Are you surprised?
There are two aspects which I don’t like about the above position:
- The fact that there is unlimited risk. If one is incorrect with the direction, can lose big money (and eventually law of averages or the dynamic nature of the market will get you).
- Statistic percent is just 33%. There are three possibilities –
- Underlying can move favourably
- Underlying does not move (small loss to cover overnight fees for leverage)
- Underlying moves in wrong direction
How can Options help me control risk and leverage of a position?
As an Options investor, you have numerous ways to control risk and leverage while shorting the market. Following are a few options –
- Bear PUT spread – with a bear put spread, you can define the amount of risk you want to take with this position.
- Sell CALL Option – when you sell a CALL option, you receive premium. Your statistical chances of winning is 66%, because even when the market at expiry ends unchanged, you’ll pocket the premium. The downside is unlimited risk if market moves against your assumption.
- Sell CALL spread – with a call spread, you define the amount of risk, but still have a 66% chances of winning.
- Buy PUT Option – when you buy a PUT option, you are expecting the market to move down. You will make money only if the market moves down more points than what you paid to buy the option. Personally I would never buy an Option contract, because the statistical chances of winning are really poor. You would want do buy as part of a spread or hedge against other positions.
As explained above, you can see that with options you can tailor your risk and also increase the statistical chances of your trades. You also have the benefits of leverage for which one uses Futures or CFDs.
If you agree with me or have any questions, please drop a comment below. You could also use the buttons below and share this articles with your friends. Also please let me know what articles, you would want to see in the future.
At some point, we will also run a model portfolio, so beginners can benefit observing the trades.
