Comprehensive Guide to Risk Management Strategies and Applications

This report provides a detailed overview of risk management strategies, which are crucial for businesses to effectively handle potential risks. It defines a risk management strategy as a structured approach to address risks, emphasizing that it's a cyclical process involving identification, assessment, m...Read More

Risk management strategy definition
A risk management strategy is a key part of the risk management
lifecycle. After identifying risks and assessing the likelihood of them
happening, as well as the impact they could have, you will need to
decide how to treat them. The approach you decide to take is your risk
management strategy. This is also sometimes referred to as risk
treatment.
There are four main risk management strategies, or risk treatment
options:
 Risk acceptance
 Risk transference
 Risk avoidance
 Risk reduction
Choosing the right one will mean the difference between managing
each potential risk effectively or facing serious consequences that could

damage your business. Let’s take a closer look at what these four
approaches involve and some examples of when you could use them.
Types of risk management strategy
Risk acceptance
Risk acceptance definition: A risk is accepted with no action taken
to mitigate it.
This approach will not reduce the impact of a risk or even prevent
it from happening, but that’s not necessarily a bad thing. Sometimes the
cost of mitigating risks can exceed the cost of the risk itself, in which
case it makes more sense to simply accept the risk. After all, why spend
£200,000 to prevent a £20,000 risk?
However, this approach does come with a gamble. You will need
to be sure that, if the risk does occur in the future, then you will be able
to deal with it when the time comes. Because of this, it is best to accept
risks only when the risk has a low chance of occurring or will have
minimal impact if it does occur.

Risk transference
Risk transference definition: A risk is transferred via a contract to
an external party who will assume the risk on an organisation’s behalf.
Choosing to transfer a risk does not entirely eradicate it. The risk
still exists, only the responsibility for it shifts from your organisation to
another.
An example of this would be travel insurance. You don’t accept
the risks of a lost suitcase or an accident abroad and the costs that this
would bring – you pay a travel insurance company to bear the financial
consequences for you.
The same goes for the workplace. You may outsource work – and
the risks that come with it - to a contractor. In finance, you may adopt a
hedging strategy to protect your assets or investments.
Risk avoidance

Risk avoidance definition: A risk is eliminated by not taking any
action that would mean the risk could occur.
If you choose this approach, you are aiming to completely
eliminate the possibility of the risk occurring. One example of risk
avoidance would be with investment. If, after analysing the risks
associated with that investment, you deem it too risky, then you simply
do not make the investment.
Treating risks by avoiding them should be reserved for risks that
would have a major impact on your organisation. If you avoid every risk
you come up against, then you may miss out on positive opportunities.
You never know, that investment you decided not to make could have
paid off. That is why it’s important to thoroughly analyse risks and make
the most informed judgement you can.
Risk reduction
Risk reduction definition: A risk becomes less severe through
actions taken to prevent or minimise its impact.

Risk reduction is a common strategy when it comes to risk
treatment, and is sometimes known as lowering risk. By choosing this
approach, you will need to work out the measures or actions you can
take that will make risks more manageable.
One example of risk reduction would be within manufacturing and
the risk of products being produced to incorrect specifications. Using a
quality management system can lower the chance of this happening, so
this would be a method of risk reduction. In the finance industry, you
may face risks associated with new regulations. Implementing a digital
solution to help you manage regulatory requirements can mitigate the
risks of non-compliance and would therefore also be an example of risk
reduction.
So which strategy should you choose?
As you can probably guess, that depends on the risk. You will need
to fully understand each risk your organisation faces so that you can

choose the appropriate strategy to treat them – whether that’s through
acceptance, transference, avoidance or reduction.
Now that you understand ‘what is a risk management strategy?’,
find out how our risk management solutions can help you make
informed decisions quickly by providing greater awareness and visibility
of risks, and more.
1. 10 Types of Risk Management Strategies to...
Having a strong approach to risk management is more important
now than ever in today’s dynamic risk environment. Following these ten
types of risk management strategies can better prepare your business for
a volatile risk landscape in 2021 and beyond.
81% of audit and risk professionals polled by AuditBoard in
October 2020 believe risk will continue to be dynamic & unpredictable
in 2021.

McKinsey found that when banks shut branches and corporate
offices, it altered how customers interact with them, forcing changes to
long-held risk-management practices in order to monitor existing risks
and guard against new ones.
Regardless of industry, how quickly and effectively risks can be
identified and managed will determine how well companies and
institutions will recover and rebuild — and this requires rethinking risk
management strategies. As organizations increase their focus on
identifying, mitigating, and monitoring risks in response to an ever more
volatile risk environment, you may have questions about who is
responsible for developing a risk management strategy and what are the
different risk management strategies? Here’s everything that you need to
know to better address today’s top risk areas.
What Is a Risk Management Strategy?
A risk management strategy is a structured approach to addressing
risks, and can be used in companies of all sizes and across any industry.

Risk management is best understood not as a series of steps, but as a
cyclical process in which new and ongoing risks are continually
identified, assessed, managed, and monitored. This provides a way to
update and review assessments as new developments occur and then to
take steps to protect the organization, people, and assets.
Identifying Risks
Risk identification can result from passively stumbling across
vulnerabilities or through implemented tools and control processes that
raise red flags when there are potential identified risks. Being more
proactive rather than reactive is always the best approach to reducing
risk points.
Assessing Risks
Once potential risks have been identified, each risk should be
assessed to determine the likelihood of it becoming a concern, its level
of severity, and the probable impact — this helps audit teams prioritize
each risk. Whether your audit team is conducting a risk assessment for

Sarbanes Oxley (SOX) or focusing on other types of risks, your
assessments should be systematic, documented, and, depending on your
business, reviewed at least annually. How often risk assessments are
completed will differ, depending on the size and complexity of each
business.
Responding to Risks
After assessing risks, the next part of the process involves
developing and implementing treatments and controls, enabling the
organization to address risks appropriately and effectively deal with each
risk in a timely manner.
Monitoring Risks
Risk monitoring is the ongoing process of managing risk by
tracking risk management execution, and continuing to identify and
manage new risks. Monitoring risks enables prompt action if the
likelihood, severity or, potential impact of a risk exceeds acceptable
levels.

Why Is Having a Risk Management Strategy Important?
Project and operational risks are not uncommon to most
businesses, but having risk management processes and strategies are
essential in identifying your company’s strengths, weaknesses,
opportunities, and threats (SWOT) — also known as conducting a
SWOT analysis. There are many other benefits to effectively managing
risks.
1. Operational Effectiveness and Business Continuity
No matter how well prepared your business is, operational risks
can surface at any time — and from sources that you may not have been
aware of in the past. Risks can take the form of a new cybersecurity
threat, a supplier or service provider that’s no longer able to service your
company, or an equipment failure. With all the moving parts both in a
company and outside of it that have an impact, having an established
risk management process and a strategy in place that allows you to

ensure internal controls to prevent fraud are in place — or to deal with
other types of risk as they arise.
2. Protection of Your Company’s Assets
Whether it’s physical equipment, supplies, or information,
protecting your company’s assets is imperative. A recent report by IBM
shows that over 8.5 billion records were compromised in data breaches
between April 2019 and 2020 — with the average cost of a mega-sized
data breach being $3.86 million US. In the one-year period ending April
2020, 80 percent of thefts were customer-related personally identifiable
information (PII). This makes establishing a solid and actionable risk
management strategy imperative from a business insurance perspective.
3. Customer Satisfaction and Loyalty
Your company’s logo, brand, digital presence, and reputation is
also an asset — and your customers take comfort in seeing and
interacting with them daily. When your business has a well-thought-out
and developed risk management plan and acts on it, your customers can

maintain a sense of security and confidence about your reputation and
brand. Your risk strategies and processes help you protect your brand
and reputation by safeguarding these assets. It also ensures that
customers can maintain faith in your ability to be there and deliver the
products and services to which you’ve committed. The result is a higher
degree of customer satisfaction and loyalty.
4. Realizing Benefits and Achieving Goals
A significant part of finishing projects on time and achieving the
intended goals relies on how effectively risks are managed. Risk
management identification, assessment, and management practices
expose vulnerabilities faster — and allow your company to remove
projects and activities that simply don’t produce a return on investment.
This increases the chance of achieving your expected project portfolio
and wider business performance and reaping the anticipated benefits.
5. Increased Profitability

The bottom line for most businesses is remaining profitable. Often
when something like a breach occurs, there is a substantial financial
impact — and it usually involves tedious hours working with legal and
insurance teams to conduct lengthy investigations. Managing market,
credit, operational, reputational, and other risks is vital to keeping your
company’s bottom line healthy.
What Are 4 Examples of Common Risk Responses?
Managing risks can involve applying different risk responses to
deal with varying types of risk. Not every risk will warrant the same
response. You’ve likely heard the adage, “Avoidance is not a strategy.”
Well, believe it or not, when it comes to risk management strategies,
avoidance is a common risk response — along with reducing, accepting,
and transferring. Here’s what you need to know about each risk response
and when they might work best.
1. Avoiding Risk

Avoidance is an option that works to remove the chance of a risk
becoming a reality or posing a threat altogether. If a product isn’t
working well but doesn’t present any potential risk to the health or
safety of employees or the company then avoiding the risk may be the
best option. One example may be avoiding the use of a piece of faulty
equipment — but only if it isn’t needed and it doesn’t impact
performance, productivity, or safety. Avoidance shouldn’t necessarily be
used with frequency or for longer-term threats. Eventually, this response
should be re-evaluated to find other sustainable risk responses that
address underlying issues.
2. Accepting Risks
Sometimes avoidance isn’t an appropriate response, and
acceptance may be the better practice. When a risk is unlikely to occur
or if the impact is minimal, then accepting the risk might be the best
response. Timing also plays a role — it could be that a risk doesn’t pose
any imminent concern, or it won’t impact your company’s strategic
outlook. One example might be a change to vendor pricing or delivery

down the road. It’s important to keep re-evaluating these types of risks
periodically: their impact on your company and its projects could
change.
3. Mitigating Risks
Mitigating risks is the most commonly discussed risk response —
however, it isn’t always practical or possible. It may be the best option if
a risk poses a real threat or problem, and avoidance or acceptance won’t
suffice. If a risk creates a negative impact and one that could be costly to
your company, employees, vendors, or customers, then that risk should
be mitigated. This means identifying the risk, assessing all possible
solutions, devising a plan, taking action, and monitoring the results.
4. Transferring Risks
There will be times when challenges or issues arise and you or
your team may not be able to avoid, accept, or mitigate them. One
example may be a lack of expertise or training required to address the
risks. In this case, it may be a good idea to outsource or transfer the risk

to another party — sometimes in-house, while other times it might
warrant help from an external third or fourth party.
Who is Responsible for Developing a Risk Management
Strategy?
Determining who will be the best person or function to identify,
assess, and develop a risk management strategy won’t necessarily be the
same each time — it will depend on the scope, nature, company
structure, complexity, resource availability, and team capabilities. So
who is responsible for developing a risk management strategy? It might
be the responsibility of a risk management committee member, an audit
team member, a project manager, a risk specialist, or someone else – like
an external consultant. When deciding which direction to go, other
things to consider include:
 The drivers and benefits behind developing a risk
management strategy.
 The end-to-end process, from initiation to completion.

 Other parties who can bring additional insight and
value.
 How and where to document the risk management
strategy.
 Risk management software and tools that can simplify
and streamline work.
 Conducting a formal review of the findings.
 Timing for presenting the findings.
What are the 10 Types of Risk Management Strategies to
Follow in 2021?
It’s important to know that there are many different risk
management strategies, each with its own benefits and uses. Here are ten
types to follow in 2021.
Type 1: Business Experiments
This risk management strategy is useful in running ‘what-if’
scenarios to gauge different outcomes to potential threats. From IT to

marketing teams, many functional groups are well versed in conducting
business experiments. Financial teams also run experiments to gauge
return on investments or assess other financial metrics.
Type 2: Theory Validation
Theory validation strategies are conducted using questionnaires
and surveys of groups to gain feedback based on experience. If a new
product or service has been developed or there are enhancements, it
makes sense to get direct, timely, and relevant feedback from end users
to assist with managing potential challenges and design flaws, and thus
better manage risks.
Type 3: Minimum Viable Product Development
Developing complex systems that offer nice-to-have features isn’t
always the best route. A good risk management strategy considers
building software using core modules and features that will be relevant
and useful for the bulk of their customers — this is called a Minimum

Viable Product (MVP). It helps to keep projects within scope, minimizes
the financial burden, and helps companies get to market faster.
Type 4: Isolating Identified Risks
Information technology teams are used to engaging with internal or
external help to isolate security gaps or flawed processes that might
leave room for vulnerabilities. In doing so, they become proactive in
identifying security risks ahead of an event rather than waiting for a
malicious and costly breach to occur.
Type 5: Building in Buffers
Whether it’s a technology or audit project, project managers
recognize the need to build in a buffer. Buffers reduce risks by ensuring
initiatives stay within the intended scope. Depending on the project,
buffers may be financial, resource or time-based. The goal here is
making sure that there are no surprises posing unforeseen risks.
Type 6: Data Analysis

Data gathering and analysis are key elements in assessing and
managing various risks. For instance, qualitative risk analysis can help
identify potential project risks. Conducting a thorough qualitative risk
analysis helps to isolate and prioritize risks, and to develop strategies to
address, monitor, and re-evaluate them.
Type 7: Risk-Reward Analysis
Conducting an analysis of risks versus rewards is a risk strategy
that helps companies and project teams unearth the benefits and
drawbacks of an initiative before investing resources, time, or money.
It’s not only about the risks and rewards of investing funds to take on
opportunities — it’s also about providing insight into the cost of lost
opportunities.
Type 8: Lessons Learned
With every initiative or project that your company does or doesn’t
complete, there will inevitably be lessons that can be learned. These
lessons are a valuable tool that can significantly reduce risks in future

projects or undertakings — but lessons are only useful if teams take the
time to document them, discuss them, and develop an action plan for
improvement based on what’s been learned.
Type 9: Contingency Planning
Things seldom go as planned, and while having a plan is great, it’s
seldom enough. Companies need to plan to have multiple plans or
options based on various scenarios. Contingency planning is all about
anticipating that things will go wrong and planning alternate solutions
for the type of risks that may surface and foil your original plan.
Type 10: Leveraging Best Practices
There’s a reason best practices are mentioned under risk
management strategies. Best practices are usually tried and tested ways
of doing things — and while they may differ from industry to industry
and project to project, best practices ensure companies don’t have to
recreate the wheel. Ultimately this reduces risks.

Effectively managing risk has always been critical for success in
any company and industry — but never more so than today. Being able
to identify and properly assess risks reduces missteps and saves money,
time, and valuable resources. It also clarifies decision-makers and their
teams and helps leaders recognize opportunities and the actions they
need to take. An important part of your risk strategy should also involve
managing your company’s risks by using integrated risk management
software that facilitates collaboration and visibility into risk to increase
the effectiveness of your risk management programs. Get started with
RiskOversight today!
Derivatives and risk management
The global financial crisis has brought into sharp focus the need
for sound risk management practices in all organisations including those
in the public sector. This module will provide you with an understanding
of the various financial risks faced by organisations and the ways in

which those risks can be managed. The module will introduce key tools
such as derivatives and risk mapping and also discuss the linkages of
risk management with the organisational strategic plan. The module will
also introduce enterprise risk management processes and the
implications of International Financial Reporting Standards (IFRS) for
financial risk management.
Vocational relevance
Employment opportunities in the field of risk management are
growing as a result of recent events. Derivatives and Risk Management
will be of particular interest to you if you are working, or planning to
work, in an organisation in the financial sector or in the finance division
of a company or public sector/not-for-profit organisation. The subject
matter of the course is, though, designed to be useful for managers and
prospective managers whose immediate responsibilities are outside the
domain of risk management. Given the growing catalogue of risk
management failures in all sectors - and the growing emphasis being
placed on effective risk management by all organisations - the content of

this course will provide knowledge and skills that all effective managers
should possess.
Qualifications
B862 is an optional module in our:
 Postgraduate Diploma in Finance (E83)
 MSc in Finance (F67)
 MA/MSc Open (F81)
Excluded combinations
Sometimes you will not be able to count a module towards a
qualification if you have already taken another module with similar
content. To check any excluded combinations relating to this module,
visit our excluded combination finder or check with an adviser before
registering.
Understanding Strike Prices

Strike prices are used in derivatives (mainly options) trading.
Derivatives are financial products whose value is based (derived) on the
underlying asset, usually another financial instrument. The strike price is
a key variable of call and put options. For example, the buyer of a call
option would have the right, but not the obligation, to buy the underlying
security in the future at the specified strike price.
Similarly, the buyer of a put option would have the right, but not
the obligation, to sell that underlying in the future at the strike price.
The strike or exercise price is the most important determinant of
option value. Strike prices are established when a contract is first
written. It tells the investor what price the underlying asset must reach
before the option is in the money (ITM).
Strike prices are standardized, meaning they are at fixed dollar
amounts, such as $31, $32, $33, $100, $105, and so on. They may also
have $2.50 intervals, such as $12.50, $15.00, and $17.50. The distance
between strikes is known as the strike width.

Special Considerations
The price difference between the underlying stock price and the
strike price determines an option's value. For buyers of a call option, if
the strike price is above the underlying stock price, the option is out of
the money (OTM). In this case, the option doesn't have intrinsic value,
but it may still have value based on volatility and time until expiration as
either of these two factors could put the option in the money in the
future. Conversely, If the underlying stock price is above the strike
price, the option will have intrinsic value and be in the money.
A buyer of a put option will be in the money when the underlying
stock price is below the strike price and be out of the money when the
underlying stock price is above the strike price. Again, an OTM option
won't have intrinsic value, but it may still have value based on the
volatility of the underlying asset and the time left until option expiration.
An option with a strike price at or very near to the current market
price is known as at-the-money (ATM).

Example of call options at different strike prices.
Investopedia / Sabrina Jiang
Strike Price Example
Assume there are two option contracts. One is a call option with a
$100 strike price. The other is a call option with a $150 strike price. The
current price of the underlying stock is $145. Assume both call options
are the same; the only difference is the strike price.
At expiration, the first contract is worth $45. That is, it is in the
money by $45. This is because the stock is trading $45 higher than the
strike price.
The second contract is out of the money by $5. If the price of the
underlying asset is below the call's strike price at expiration, the option
expires worthless.
If we have two put options, both about to expire, and one has a
strike price of $40 and the other has a strike price of $50, we can look to

the current stock price to see which option has value. If the underlying
stock is trading at $45, the $50 put option has a $5 value. This is because
the underlying stock is below the strike price of the put.
The $40 put option has no value because the underlying stock is
above the strike price. Recall that put options allow the option buyer to
sell at the strike price. There is no point using the option to sell at $40
when they can sell at $45 in the stock market. Therefore, the $40 strike
price put is worthless at expiration.
Are Some Strike Prices More Desirable Than Others?
The question of what strike price is most desirable will depend on
factors such as the risk tolerance of the investor and the options
premiums available from the market. For example, many investors will
look for options whose strike prices are relatively close to the current
market price of the security, based on the logic that those options have a
higher probability of being exercised at a profit. At the same time, some
investors will deliberately seek out options that are far out of the

money—that is, options whose strike prices are very far from the market
price—in the hopes of realizing very large returns if the options do
become profitable.
Are Strike Prices and Exercise Prices the Same?
Yes, the terms strike price and exercise price are synonymous.
Some traders will use one term over the other and may use the terms
interchangeably, but their meanings are the same. Both terms are widely
used in derivatives trading.
What Determines How Far Apart Strike Prices Are?
For listed options, strike prices are set by criteria established by the
OCC or an exchange, typically with $2.50 distance for strikes below
$25, $5 increments for those trading from $25 through $200, and $10
increments for strikes above $200.1 In general, the strikes will be wider
for stocks with higher prices and with less liquidity or trading activity.
New strikes may also be requested to be added by contacting the OCC or
an exchange.

Understanding Call Options
Let's assume the underlying asset is stock. Call options give the holder the
right to buy 100 shares of a company at a specific price, known as the strike price,
up until a specified date, known as the expiration date.
For example, a single call option contract may give a holder the right to buy
100 shares of Apple stock at $100 up until the expiration date three months later.
There are many expiration dates and strike prices that traders can choose. As the
value of Apple stock goes up, the price of the option contract goes up, and vice
versa. The call option buyer may hold the contract until the expiration date, at
which point they can take delivery of the 100 shares of stock or sell the options
contract at any point before the expiration date at the market price of the contract at
that time.
You pay a fee to purchase a call option, called the premium. It is the price
paid for the rights that the call option provides. If at expiration the underlying asset
is below the strike price, the call buyer loses the premium paid. This is the
maximum loss.

If the underlying asset's current market price is above the strike price at
expiration, the profit is the difference in prices, minus the premium. This sum is
then multiplied by how many shares the option buyer controls.
For example, if Apple is trading at $110 at expiry, the option contract strike
price is $100, and the options cost the buyer $2 per share, the profit is $110 - ($100
+$2) = $8. If the buyer bought one options contract, their profit equates to $800 ($8
x 100 shares); the profit would be $1,600 if they bought two contracts ($8 x 200).
Now, if at expiration Apple is trading below $100, obviously the buyer won't
exercise the option to buy the shares at $100 apiece, and the option expires
worthless. The buyer loses $2 per share, or $200, for each contract they bought—
but that's all. That's the beauty of options: You're only out the premium if you
decide not to play.

Image by Sabrina Jiang © Investopedia 2020
Types of Call Options
There are two types of call options as described below.
 Long call option: A long call option is, simply, your standard
call option in which the buyer has the right, but not the obligation, to buy a
stock at a strike price in the future. The advantage of a long call is that it
allows you to plan ahead to purchase a stock at a cheaper price. For
example, you might purchase a long call option in anticipation of a
newsworthy event, say a company's earnings call. While the profits on a
long call option may be unlimited, the losses are limited to premiums. Thus,
even if the company does not report a positive earnings beat (or one that
does not meet market expectations) and the price of its shares decline, the
maximum losses that the buyer of a call option will bear are limited to the
premiums paid for the option.
 Short call option: As its name indicates, a short call option is
the opposite of a long call option. In a short call option, the seller promises
to sell their shares at a fixed strike price in the future. Short call options are
mainly used for covered calls by the option seller, or call options in which
the seller already owns the underlying stock for their options. The call helps

contain the losses that they might suffer if the trade does not go their way.
For example, their losses would multiply if the call were uncovered (i.e.,
they did not own the underlying stock for their option) and the stock
appreciated significantly in price.
How to Calculate Call Option Payoffs
Call option payoff refers to the profit or loss that an option buyer or seller
makes from a trade. Remember that there are three key variables to consider when
evaluating call options: strike price, expiration date, and premium. These variables
calculate payoffs generated from call options. There are two cases of call option
payoffs.
Payoffs for call option buyers
Suppose you purchase a call option for company ABC for a premium of $2.
The option's strike price is $50, and it has an expiration date of Nov. 30. You will
break even on your investment if ABC's stock price reaches $52—meaning the
sum of the premium paid plus the stock's purchase price. Any increase above that
amount is considered a profit. Thus, the payoff when ABC's share price increases
in value is unlimited.

What happens when ABC's share price declines below $50 by Nov. 30?
Since your options contract is a right, and not an obligation, to purchase ABC
shares, you can choose to not exercise it, meaning you will not buy ABC's shares.
Your losses, in this case, will be limited to the premium you paid for the option.
Payoff = spot price - strike price
Profit = payoff - premium paid
Using the formula above, your profit is $3 if ABC's spot price is $55 on
Nov. 30.
Payoff for call option sellers
The payoff calculations for the seller for a call option are not very different.
If you sell an ABC options contract with the same strike price and expiration date,
you stand to gain only if the price declines. Depending on whether your call is
covered or naked, your losses could be limited or unlimited. The latter case occurs
when you are forced to purchase the underlying stock at spot prices (or, perhaps,
even more) if the options buyer exercises the contract. Your sole source of income
(and profits) in this case is limited to the premium you collect on expiration on the
options contract.
The formulas for calculating payoffs and profits are as follows:

Payoff = spot price - strike price
Profit = payoff + premium
Using the formula above, your income is $1 if ABC's spot price is $47 on
Nov. 30.
Purposes of Call Options
Call options often serve three primary purposes: income generation,
speculation, and tax management.
There are several factors to keep in mind when it comes to selling call
options. Be sure you fully understand an option contract's value and profitability
when considering a trade, or else you risk the stock rallying too high.
Using options for income
Some investors use call options to generate income through a covered call
strategy. This strategy involves owning an underlying stock while at the same time
writing a call option, or giving someone else the right to buy your stock. The
investor collects the option premium and hopes the option expires worthless
(below strike price). This strategy generates additional income for the investor but
can also limit profit potential if the underlying stock price rises sharply.

Covered calls work because if the stock rises above the strike price, the
option buyer will exercise their right to buy the stock at the lower strike price. This
means the option writer doesn't profit from the stock's movement above the strike
price. The options writer's maximum profit on the option is the premium received.
Using options for speculation
Options contracts give buyers the opportunity to obtain significant exposure
to a stock for a relatively small price. Used in isolation, they can provide
significant gains if a stock rises. But they can also result in a 100% loss of the
premium if the call option expires worthless due to the underlying stock price
failing to move above the strike price. The benefit of buying call options is that
risk is always capped at the premium paid for the option.
Investors may also buy and sell different call options simultaneously,
creating a call spread. These will cap both the potential profit and loss from the
strategy but are more cost-effective in some cases than a single call option because
the premium collected from one option's sale offsets the premium paid for the
other.
Using options for tax management

Investors sometimes use options to change portfolio allocations without
actually buying or selling the underlying security.
For example, an investor may own 100 shares of XYZ stock and may be
liable for a large unrealized capital gain. Not wanting to trigger a taxable event,
shareholders may use options to reduce the exposure to the underlying security
without actually selling it.12 In the case above, the only cost to the shareholder for
engaging in this strategy is the cost of the options contract itself.
Though options profits will be classified as short-term capital gains, the
method for calculating the tax liability will vary by the exact option strategy and
holding period.
Example of a Call Option
Suppose that Microsoft stock is trading at $108 per share. You own 100
shares of the stock and want to generate an income above and beyond the stock's
dividend. You also believe that shares are unlikely to rise above $115.00 per share
over the next month.
You take a look at the call options for the following month and see that
there's a $115.00 call trading at $0.37 per contract. So, you sell one call option and

collect the $37 premium ($0.37 x 100 shares), representing a roughly 4%
annualized income.
If the stock rises above $115.00, the option buyer will exercise the option,
and you will have to deliver the 100 shares of stock at $115.00 per share. You still
generated a profit of $7.00 per share, but you will have missed out on any upside
above $115.00. If the stock doesn't rise above $115.00, you keep the shares and the
$37 in premium income.
How Do Call Options Work?
Call options are a type of derivative contract that gives the holder the right
but not the obligation to purchase a specified number of shares at a predetermined
price, known as the "strike price" of the option. If the market price of the stock
rises above the option's strike price, the option holder can exercise their option,
buying at the strike price and selling at the higher market price in order to lock in a
profit. Options only last for a limited period of time; however. If the market price
does not rise above the strike price during that period, the options expire worthless.
Why Would You Buy a Call Option?
Investors will consider buying call options if they are optimistic—or
"bullish"—about the prospects of its underlying shares. For these investors, call

options might provide a more attractive way to speculate on the prospects of a
company because of the leverage that they provide. After all, each options contract
provides the opportunity to buy 100 shares of the company in question. For an
investor who is confident that a company's shares will rise, buying shares indirectly
through call options can be an attractive way to increase their purchasing power.
Is Buying a Call Bullish or Bearish?
Buying calls is a bullish behavior because the buyer only profits if the price
of the shares rises. Conversely, selling call options is a bearish behavior, because
the seller profits if the shares do not rise. Whereas the profits of a call buyer are
theoretically unlimited, the profits of a call seller are limited to the premium they
receive when they sell the calls.
The Bottom Line
Call options are financial contracts that give the option buyer the right but
not the obligation to buy a stock, bond, commodity, or other asset or instrument at
a specified price within a specific time period. The stock, bond, or commodity is
called the underlying asset.
Options are mainly speculative instruments that rely on leverage. A call
buyer profits when the underlying asset increases in price. A call option seller can

generate income by collecting premiums from the sale of options contracts. The tax
treatment for call options varies based on the strategy and type of call options that
generate profits.