Warren Buffet routinely employs equity options to decrease risk in stock and to obtain stock at a lesser pay out. If he is using stock options, they should be lower exposure in comparison with trading stocks alone. You can even trade equity options in your IRA. That is the frank reply, just the same continue reading to appreciate why this is correct.
On a dollar for dollar proposition, equity option trading involves less risk in comparison with stock trading over a assumed duration . For example, if you conclude Microsoft is about to build up in market value over the next two months owing to break out of Vista, you can either buy the stock for around $29.50 per share or get a $30 strike price Jan '07 call for $0.70 per share. Considering a equity option covers one hundred shares, the option charge is $70.00 to direction one hundred shares in opposition to $2950.00 to hold one hundred shares. If the equity goes up to $30.00 per share the option moves to roughly $092. You can compute this using a equity option implied volatility calculator. That limited flux in the stock results in a 30% gain on the stock option and a 1.7% return on the stock. This is refered to as leverage and is a characteristic of equity options trading. Since the options expire on the third Friday in Jan '07, make believe Microsoft moves to $35.00 per share. Using your call, you can buy in the equity at $30.00 or you can just dump your call for $5.00 per share, generating a 700% gain on the stock option.
What if Microsoft drops? If it drops around $5.00 to $24.50, you give up $5.00 per share on the equity however the most given up on the call equity option is the price you spent or $0.70 per share. That is hugely smaller exposure than owning stock if you are mistaken and the stock goes down.
When you are long (buy) a equity option your exposure is rigidly constrained to how much you spent and is all the time much less risk compared with owning the stock. The high exposure in equity option trading occurs when you short (sell) options and you do not own the equity for a call option you sell or have the money for a put option you sell. There is plenty of money to be made without engaging in this type of trading.
Did you know you could even cast off the need to forecast whether a stock is going to move up or down? You can engage in direction nonspecific stock options trading, such as option backspread trading, to generate income if the equity moves either up or down. The exposure in these trades is restrained to your original cost. Sometimes you can even make some direction unspecified stock option trades at no cost.
Equity options can among other things be employed to diminish your exposure in equity ownership. If you own a stock that is not advancing, something that most stocks do nearly 80% of the time, write a call option with strike price greater than stock cost and cover the option with that flat stock your equity cost. For example, imagine you paid $25 per share for equity and sell a $27.50 strike call option for $0.50 per share. If the equity goes to $27.50 when the option expires , you must deliver the stock at $2750. You would acquire a total of $3.00 per share ($2.50 on stock and $0.50 on option). When the stock moves down or does not exceed $27.50 by expiration, you get to keep the equity and the amount you were paid when you sold the call option. That is equal to generating your own $0.50 per share dividend. Correspondingly it reduces your cost in the equity by $0.50 per share. As a result the most you can lose on that equity is 24.50, not the original $2500.
So to answer the question, equity option trading performed correctly is eminently less exposure than stock trading. Equity options allow you to diversify a great deal better with same core of equity capital. The exposure in option trading that is not present with stock trading is their constrained lifetime. Equity options do expire. This means your forecast for the equity movement has to materialize within the time context of the options you use. This can range from 1 day to approximately 3 years.
Go online and investigate equity option trading and the even lower risk found in implied volatilitytrading.