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Author: rbnelson Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1203  
Subject: Re: Selling Short Versus Options Date: 6/6/2006 5:17 PM
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...my discount broker and he said that selling short is safer than using options...
Are options more or less risky than selling short?



IMO, it's more accurate to say options are more volatile than stocks (short or long) but they aren't necessarily more risky. The risk depends upon how much you choose to invest. Perhaps an example is in order.

The other day I suggested knowing your an entry price, target price, and stop loss price before taking a position. Let's rewind the clock to Monday contrast bearish positions against the QQQQ's by shorting it and buy buy options (puts).

Short QQQQ
On Monday you could have gone short at $39.00 during the mid day. Say we anticipate the QQQQ's to take another leg down to $37 very soon so that's our target. Since the big May slide, it did hit a recent high of $40 so we decide to use $41 as our stop loss just in case the market breaks out and decides to rally instead.
- Entry of $39
- Target of $37
- Stop loss of $41

Options QQQQ - Jun 06 Puts w/ strike of $38
On Monday, those options could have been picked up for about $15 per contract (on 100 shrs). Options are a little more difficult to pick a target but we've in essence done so with the strike of $38, so we'll say our target is for the QQQQ to reach $37. That would give us roughly $100 per contract less the $15 premium, or $85 profit per contract. For simplicity sake, we'll hold the contract till expiry so our stop loss will be when the contracts expire worthless.
- Entry of $15
- Target of $37 ($1 below strike price)
- stop loss of $0 (or stated another way, we could lose our entire investment)


You have a $10,000 portfolio.
How do you compare these investment options?
How many shares or contracts do you buy?


Enter the Risk Management Plan. Let's say your plan dictates the following: Upon entry...
- no position will be greater than 20% of portfolio
- no position will risk more than 0.5% of portfolio

That immediately limits your position to a max of $2,000. That would allow you to short 51 shares of QQQQ or buy stocks you could buy 133 options on QQQQ.

Now lets look at the risk contraint. With a 0.5% risk on $10k we're talking about capping our losses at $50. In the case of shorting 51 shares of QQQQ, covering at 41 would result in a loss of $102. You can only invest $936 to short 24 shares and still stay within your risk limits. On the Options side, there is no way you can purchase 133 contracts because you risk losing your entire investment if the options expire worthless. At $15 a contract you can invest $45 to purchase 3 contracts and still keep your max lose at or below $50. Note the difference in the amount invested.

Now compare the potential gains. We're looking at the upside of shorting 24 shares of QQQQ and buying 3 contracts of puts w/ strike of $38. If the QQQQ's drop to $37, you've invested $936 and are sitting on a $2/shr profit or $48 (a 5.1% return). With the puts, they will have expired in the money which gives you the right to sell shares of QQQQ for $38 which is a $1/shr profit on 300 shares which is 300 less the $45 cost of the option. That $45 investment results in a $255 profit or 566% return.

If your eyes are twinkling at the huge profits, you've missed the point and your focusing on the wrong thing. The key is to control your risk or potential loss. That's what allows you to sleep at night. Options aren't necessarily more risky if you control your risk. If you don't then your broker is absolutely right.

Regards
RB

PS - Russ from Real Time Trader deserves props for much of this. He's a regular on some of the TMF boards.
http://www.therealtimetrader.com/realtimetrader/understandingriskreward.htm
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