The fluctuating nature of stock trading leaves some would-be investors wary about the idea of risking funds in an inherently unpredictable market. There are, however, many investment risk management strategies that can help better protect your investment.

A safer way to not risk it all is by trading with options, which allow investors to invest in a share at a lower rate than its actual price. By investing in options you reduce the risk and cost of buying full ownership of shares without losing profit-yielding potential.

How do options work? They basically give the buyer the right—not the obligation—to buy or sell stocks at a pre-specified price within an agreed upon time-frame. The strategy is speculative in that rather than committing to outright stock ownership, options investors make predictions about the future of a stock and then make decisions based on its performance over time. If predictions surrounding a particular option do not work out in the investor’s favor, they may let the option expire, thereby incurring the initial cost of buying the option itself, but avoiding huge potential losses if they had purchased the stock outright.  

Options can be cheaper and more risk-averse. But they are not entirely without their drawbacks. Not having full ownership of stocks, as well as the specific time-frame corresponding to the investment, can both have their limitations.

The main type of option is called a put option, which involves paying for the right to sell an asset at a predetermined price within a predetermined period of time. Put options represent an effective risk management strategy against a stock falling or a market-wide crash. For instance, if you buy a three-month put option for a certain stock at $50 a share, if that stock’s price happens to drop to $25 a share within those three months, you are then able to sell your share at $50, and avoid the losses you would have incurred if you owned the stock outright. Conversely, if that $50 price rises over that three-month period, you can let the option expire while profiting from the share’s increased value. There would be some degree of loss in terms of what was initially invested in the option itself, but the profits made by the underlying stock may compensate for that.

Call options work conversely to put options in that they give you the right to purchase shares at a specified price in a specified time-frame. This method also involves a high degree of speculation. For instance, if a particular share is currently trading at $50, and you predict that its price will increase to $60, you may buy a three-month option to buy, say, 100 shares. Let’s say you pay $100 for this call option (at a rate of $2 per share to do so). If that share does, in fact, climb to your predicted $60, then you’ve made significant profit without risking the potential volatility of owning the shares outright. However, if that price drops, then you can let your call option expire, ultimately losing $100. You stand to make at least $1000 in profit if you predicted correctly, or $100 in losses if not.

Options trading is highly speculative in nature and shouldn’t be attempted by the novice investor without first doing thorough research about the particular stocks in which they are interested in investing. Further, consulting with a financial professional is highly recommended. Although consulting fees may come at a price, consider these costs an investment against future losses.

Options should also represent only one form of asset trading in an otherwise diverse portfolio. Your investment portfolio would do well to include many forms of assets, from individual stock to mutual funds to ETFs. By diversifying an investment portfolio losses experienced in one area can be compensated by the gains in another.

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