Options trading is one of the most exciting areas of the financial markets, offering the potential for significant profits if you set up the right trade. But this potential for big profits comes with huge risks, and it can be easy to mess up your investment portfolio if you make the wrong trade. So it’s key to understand the risks of options trading and how to navigate those risks effectively.
Here are some of the biggest risks in options trading and the key things to be aware of.
7 big risks of options trading
1. Inputting the wrong trade
It doesn’t get more basic than an investor putting in the wrong trade, and it can be incredibly easy to do, especially if you’re in a hurry. In fact, you can all too easily set up a trade that’s exactly the opposite of what you intended to do. For example, you might sell calls when you intended to buy them, creating a potentially huge risk if you don’t close the trade and the underlying stock soars.
Of course, it’s not just getting the buy/sell option wrong. The option chain for any stock often has dozens of different choices available, depending on the strike price and the expiration date. Throw in the potential to pick the wrong strategy — calls or puts — and a little bit of haste to get a trade done in a fast-moving market, and it’s all too easy to set up the wrong trade.
2. Investment thesis has to be right
You’ll need an investment thesis for the stock you’re buying the option on, that is, how you expect it to perform. This thesis guides the type of option strategy you want to pursue. If you think a stock might soar, then you might buy calls, while if you think it might plummet, you could buy puts. More advanced options strategies allow you to wager on a slow rise in a stock, too.
Matching the right strategy to the thesis is vital, but you’ll still wind up a loser if the investment thesis on the underlying stock doesn’t play out. If your option strategy pays off only if the stock soars and then the stock doesn’t, you’ll likely wind up with a handful of worthless contracts.
3. The timing has to be right
The part that makes options trading doubly hard is that only does the thesis have to be right, the timing of the trade has to be right, too. Options have a finite lifetime, and once they expire, they’re settled up among the traders and then cease to exist. You can have the right thesis, but if it doesn’t play out before the option expires, then you’ll also wind up with worthless options.
That point is worth reiterating: Even if the underlying stock matches the investment thesis the day after your option expires, you will not be able to profit from the expired options trade. Again, the options trader has to nail the investment thesis and the timing to earn the expected return.
4. Time can eat away your option’s value
Time plays a significant factor in options pricing. The more time until expiration, the more time your investment thesis has to be right. That extra opportunity comes at a higher option premium. So, all else equal, a longer-lived option will cost more than a shorter-lived option.
This fact means that as the time to expiration declines, the value of the option declines, too. It’s what options experts call “theta decay,” referring to the Greek letter theta, which represents the change in the option price relative to the change in time. Here time really is money.
Traders who buy options suffer from theta decay, while those who sell them — such as those who write covered calls — benefit from the approaching expiration date. The best options brokers have tools that can help you understand options pricing and how they can be affected.
5. You can lose way more on options than you earn
Some options strategies expose you to much more downside than upside, namely selling options. For example, selling put options can act like a form of insurance, with the trader getting an upfront payment and then agreeing to purchase the stock if it falls below a certain price.
If the stock rises or stays flat, the trader keeps the premium payment. However, if the stock falls, the trader has to purchase the stock at the strike price. And the stock could fall so much that the trader could easily lose five or 10 times the value of the premium that was received.
In options the potential for significant profits is exactly equal to the potential for significant risk. In other words, one trader’s gains on a contract match another trader’s losses down to the dollar.
6. Declining volatility affects your options prices
A less volatile stock price may seem like a good thing, but it actually causes the value of related options to fall. The effect is measured using the Greek letter vega, which measures the change in the option price relative to the change in the stock’s volatility. A more volatile stock can offer more potential outcomes — i.e., it can go a lot higher in a shorter period of time. Therefore, options on highly volatile stocks are priced higher to account for the wider range of outcomes.
Options traders exploit this pricing. For example, traders may want to “sell vol” when a stock is especially volatile and they can get a higher price for the option than otherwise. Conversely, option buyers want to buy when less volatility is baked into the option price, to get a better deal. So if a stock becomes less volatile, the option will decline in value to reflect this fact.
7. Traders may have to put up a lot of cash at an inopportune moment
If you’re short options — having sold calls or puts — then you may be forced to put up cash if someone exercises the options you sold them. That means you’ll need enough cash in your account or sufficient margin capacity to settle the obligation. While this obligation could come at any time, it happens most often as an option approaches expiration and has little time value left.
Your broker will be keeping track of this situation and may issue a margin call if you may owe too much. Unfortunately, often traders may be in the unenviable position of being forced to put up cash for their short contracts when other assets — which could be sold for cash — are falling, too.
Bottom line
Options trading can be highly lucrative but investors have to deal with a lot of risks on the way to getting those high returns. Still, options trading does offer some relatively safe strategies that are even available to beginners, though it’s vital to know the risks of any trading strategy.
Read the full article here
