Options trading is risky, don't lose your shirt!
Options trading is a high-risk investment with the potential for huge rewards. If you’re not careful, it can be dangerous to your wealth and even your life.
Professional traders are often successful because they do their homework before investing in options. And they take time to understand all of the risks involved. But when amateurs trade options, many of them fail to think about the risks and end up losing everything or worse – going bankrupt!
The most common problem is that amateur investors don’t know how to manage risk by diversifying their portfolios or use stop-loss orders so that if prices fall quickly on an asset, then they won’t go below a certain level and become worthless. I hope this article has helped you learn some valuable lessons.
Risks in Options Trading – An Introduction
Options carry way higher risks and rewards than the underlying assets. The prices of the options move following the price movement of the underlying assets, i.e., stocks, currencies, or any other asset. People choose to trade on options because the capital required is comparatively less, but if the market does not move in the direction as expected, at the right time, the value of the options depreciate really fast, once the price of the underlying asset starts moving in the opposite direction as the investor might have expected.
Moreover, as options get nearer to the expiry date, the value will start depreciating due to time decay. If the options held are out of the money, they will be of practically no value on or after the date of their expiry. An investor may plan his investment by looking up the parameters such as a change in open interest, implied volatility, delta, gamma, and use all other methods, but the risk is still a major part of this trade.
It takes a lot of planning and expertise to pick good option calls and puts, and carry out good options trades consistently, so an investor must be fully prepared while buying an option.
What are the Different Risks Involved?
1. Potential Losses
Options are usually considered flexible and can be invested into, with a wide range of strategies. Options have been conventionally used to protect an investor’s portfolio against the losses incurred by the market.
Using well-planned strategies, one can invest in options and appropriately estimate the maximum potential loss, which can be very helpful for an investor. However, options trading is widely considered risky and sometimes it can lead to huge losses. Although one makes fewer mistakes as one grows in experience but even the most experienced traders are not unknown to huge losses in trades and thus, it is very important to know the risks involved.
A major advantage that is often talked about among investors is one can use leverage to multi-fold one’s investment. Let’ say, an investor bought INR 1,000 worth of call options based on Company A stock. It is a general practice that if that stock’s price goes up, investors directly invest that INR 1,000 into the stock.
But here lies the trick. On the contrary, if the stock’s price falls, or remains the same, the call options may end up worthless and this leads to the loss of the entire amount invested. On a better judgment, if the investor had bought the stock instead, he could only lose all INR 1,000 invested if and only if Company A went bankrupt. This simple example clearly shows a major risk involved while investing in options.
2. Risks due to Options going out of money at expiration
Options expiration is the time after which it becomes worthless. After an option expires, the investor has no right to the contract. Moreover, the investor loses the premium and any other fees or commissions related to the option after its expiration.
An option’s value is highly influenced by the relation between the option’s strike price and the current market price of the underlying asset. For call options, if the underlying asset’s price is above the strike price it is said to be in the money. On the other hand, if the underlying asset’s price is below the strike price, the option is said to be out of the money. It would be a bad judgment to strike the call when it would be better to invest in the stocks at better prices. It is always better to buy the underlying shares instead of exercising the option if it goes out of money because the shares would be easily available at a better price.
For a call option, its total value is lost if the underlying asset’s price reaches below the strike price at the time of expiration. On the contrary, a put option loses all its value if the underlying asset’s price is above the strike price at the time of expiration.
In both cases, the option becomes valueless and the investor loses the premium.
Although it to possible to protect oneself from loss due to the nearing of the expiration of the contract, it becomes very difficult at such points in time and can lead to grave mistakes from the investor.
3. The Complexity of Contracts and Cost of Trading
a. Complexity of Contracts
It is quite known among the masses that options trading is complex and the complexities involved in the contract itself are quite a big risk to deal with. Although it is easy to understand the basics of options trading, the strategies involved and some advanced concepts can be very difficult to grasp and dealt with. It is common for investors, in the beginning, to not fully understand the contracts and the market which leads to losses.
An investor can overcome this risk by regularly reading articles and books, including advanced topics. Moreover, one should only use strategies that he is quite comfortable with. Building this knowledge step by step can increase confidence, but one has to gain experience to minimize this risk.
If you want to learn all the complex terms in a simple manner, can check our Option Strategies: A Mentorship Program
b. Cost of Trading
The bid price is referred to the price an investor receives for writing an option and the asking price is defined as the price an investor pays to buy an option. The bid price is always lower than the asking price.
The spread is defined as the difference between the asking price and the bid price of an option. It is an indirect cost of trading options. The cost increases with the increase in the spread. A lack of liquidity leads to bigger spreads and thus bigger risks.
The direct costs involved in trading options especially the commission taken by the broker are generally higher than in other investments. Such facts should also be considered in the cost before investing in an option.
4. Idiosyncratic Risk (Individual Stock Risk)
Idiosyncratic risk also called the Individual Stock Risk or Unsystematic Risk is referred to the risk that shares of a company are exposed to vis a vis the events that affect that company. For example, if an investor buys shares of Company A, he runs the idiosyncratic risk that the company might go bankrupt in the future.
A call or put option’s price is directly affected by the market price of the underlying asset, i.e., stock, gold, currency, etc. When the value of the underlying asset increases the call option price rises and the put option price falls. Similarly, when the price of the underlying asset decreases the call option price falls, and the put option price rises.
This is an options trading risk that affects option traders who put all their money on the options of a single stock most. If one invests in the options of only a few stocks, the idiosyncratic risk increases. Usually, the strike by such a risk is very unpredictable, leading to the destruction of one’s portfolio. Such risks can be lowered, but it requires deep knowledge of the sectors invested in. Thus, it is very time-consuming making it a burden to become consistent with the ongoings in the sectors the investor is involved with.
5. Liquidity issues
Liquidity is the measure of how easily an investor can buy or sell an asset without affecting the current market’s price. The liquidity of an option is directly proportional to the fact that how much the option is being traded. Although, the number of people investing in options has considerably increased in the past few years options can still pose issues regarding liquidity. As there is a vast variety of options being traded regularly, an option you wish to trade might be having a very low volume being traded. The more liquidity of an option, the easier it is to move in and out of the option.
Sometimes liquidity for particular options gets very bad, leading to a huge decline in interests, sometimes in factors of a hundred.
Liquidity issues in options may lead to huge losses. Unexpected liquidity makes it uneasy to make the right trades at the right times, sometimes leading to losses. Usually, liquidity is not a great issue while trading in very small volumes or while trading popular options, but for trading large volumes or fewer mainstream options it generally poses larger risks. Most exchanges usually use market makers to keep liquidity in check, but the problem still persists many a time.
6. Decay with time
With the nearing date of expiration, the value of an option decreases. This phenomenon is known as Time Decay. The time value of an option is the reference to the extent of influence time has on the value or the premium of an option. The rate of time decay increases as the expiration date approaches because the time for an investor to make a profit also decreases with the nearing of the expiration date.
This phenomenon of Time Decay starts with the option being bought and continues till expiration.
Even if the value of the underlying asset does not change during a period, the loss of time value has to be borne by the investor. Time Decay increases at a higher rate if the option is out-of-the-money (OTM) or if the option is not profitable. The reason behind this is that as time passes, it is less likely that the option will become in the money.
The Greek Theta can be used to estimate the Time Decay. Theta refers to the reduction in an option’s value, which happens as it nears its expiry date. Theta has a negative value for both Call and Put since it leads to a reduction in each of the option’s values.
If the value of Theta is -0.6 it means that the option premium loses 0.6 points each day that passes.
Let’s say an option is trading at INR 5.50. If the value of Theta is -0.07 then the option will trade at a lower price of INR 5.43, the next day, if all other conditions are constant.
Other General Risks in Options Trading
Many investors are aware of the risks that option trading poses. It is an undeniable statement that options trading is not a piece of cake. It is a unique way to invest. Options trading also has certain pitfalls and downsides like other forms of investment. Although most of the risks have been explained in this article, there are some more points an investor might consider while investing in options. Some of these have been presented below.
- Sometimes, complex trading strategies impose further risks.
- The Options markets have the power to stop the trading of any options at any time, which might trouble some investors.
- Options are always at the risk that the exercising value may be falsely reported.
- Trading options Internationally have further risks due to timing differences.
- Options leverage is as risky as it seems profitable.
- The terms and conditions of an option contract or the options exchanges can change at any time.
- Traders must meet certain requirements before starting which are checked by the brokers. Moreover, a broker assigns the investor a trading level that tells the types of options the investor is allowed.
Although the article reflects the disadvantages of options trading, there are plenty of reasons which prove that trading options are a good idea for an investor. Many investors have made great profits from options and anyone can follow in their footsteps. Before considering investing in options, one’s decision should be based on the fact if the advantages of trading options outweigh the risks involved in their personal view.
Conclusion:
Options trading is a high-risk investment with the potential for huge rewards. If you’re not careful, it can be dangerous to your wealth and even your life.
The key to successful options trading lies in managing risk effectively through tools like position sizing, diversification, hedging strategies and more. We have been helping clients manage their risks since 2011 so give us a call today or enrol on our Option Strategies: A Mentorship Program, if you want help figuring out how best to grow your portfolio safely while still earning some great returns! Which methods are you using to manage your risk? Let me know in the comment box.
Few Articles you should read:
- What is Intraday Trading? The best guide for beginners in 2024
- What Wikipedia Can’t Tell You About Trade Options for a Living
- Trading Psychology: The Mental Strength to Stay in the Game
Options Strategies – A Mentorship Program
On the 1st of September, we launched a new mentorship program for Option strategies, in which we’ll discuss how can we deploy these strategies. What rules we should follow before taking a trade? and what should be our adjustments if the script is moving against your direction?
Learn how to generate your Monthly Cheque from Option strategies with Sachin Sival
DISCLAIMER: – we are not a SEBI research analyst. Views posted here only for educational purposes. There is no liability whatsoever for any loss arising from the use of this product or its contents. This product is not a recommendation to buy or sell, but rather a guideline to interpreting specified analysis methods. This information should only be used by investors and traders who are aware of the risk inherent in securities trading.
