Risk involved in options trading

Are there any risks involved in trading put options through a traditional broker?

All option trading involves risk. Put option trading designed to take outright directional positions may be more difficult than similar call option trading. There really aren't any differences in the amount of risk borne when using a traditional, online or direct access broker. Direct access brokers may be faster.

There are standardized put options for thousands of stocks traded at the Chicago Board Options Exchange (CBOE) and put options for futures traded at the Chicago Mercantile Exchange (CME). Options and futures are both types of derivative contracts. Other over-the-counter (OTC) option contracts are available as well.

Different types of options market participants face different types of risks. There are option buyers, option sellers, covered option writers and naked option writers.

Put option buyers face the risk that the underlying security won't behave as expected and their premiums could lose all of their time values. If the price in the market is above the strike price at expiration the option will expire, worthless. Losing the entire premium is a common occurrence in out-of-the-money put option buying. Buying in-the-money puts helps reduce a portion of this risk. An option seller is merely someone who already owns a put option selling it. Option sellers are different from option writers.

Covered option writers hold a qualifying short position. They sell options on the positions they hold. Those who write puts with out-of-the-money strike prices face the risk that the price of the underlying asset could fall below the strike price and their counterparty could exercise the option. They may have the short position called away.

Naked option writers face all the risks faced by covered option writers with the added risk of the necessity of entering a short position losing value quickly in the open market in order to stop losses from mounting in losing naked option obligations. Naked put option sellers write options for underlying positions which they do not posses, gambling that they will expire out-of-the-money, enabling the sellers to pocket the premiums collected. This can be profitable for a time, but often ends in a large loss, which wipes out most or all accumulated profits.

Risks Involved With Trading Options.

In our introduction to options trading we have already provided a detailed explanation of what options are and what trading them entails, along with an overview of all the advantages. If you are seriously considering this form of trading as part, or all, of your investment strategy, then these basic topics are important to know.

It's also advisable that, before you actually get started, you also understand some of the downsides to trading options and the risks involved.

With any form of investing, your capital is ultimately at risk to some degree as soon as you invest it, and options trading is no different. While there a number of ways that you can limit your risk, through using the appropriate trading strategies for example, there are certain direct and indirect risks that you really should be aware of. On this page, we provide further details on this, covering the following:

Potential Losses in Options Trading.

One of the many reasons that investors choose to trade options is due to the flexibility and versatility they offer, and the wide range of strategies that can be used. In particular, there are a number of strategies that can be used to either limit the risk of taking a position or reduce the upfront costs of taking a position.

With some of the limited risk strategies, it's possible to enter a trade and know exactly what the maximum potential loss is, which can be very useful when planning trades. However, options trading is widely considered to be high risk and it's certainly possible to make significant losses. Obviously, the more you learn and the more experience you get the less likely you are to make catastrophic losses, but even experienced traders can make mistakes and it's important to know what sort of risks you are exposed to.

A major advantage that is often mentioned is the fact that you can use leverage to effectively multiply the power of your capital. For example, if you bought $1,000 worth of call options based on Company X stock then you could stand to make much bigger profits. If that stock went up, then you should directly invest that $1,000 into the stock.

However, the flip side to this is if the stock fell in value, or even just remained the same, your call options may end up worthless and you would lose your entire $1,000. Had you bought the stock instead, you would only lose all that $1,000 if Company X went bankrupt. This highlights a major risk, that it's possible for options that you buy to expire worthless, meaning you lose anything you invested in those contracts.

Equally, when writing options, you can possibly lose large sums of money if the underlying security moves dramatically in price in an unfavorable direction. There are steps that you can take to limit losses, such as using stop loss orders or creating spreads, but it's vital that you are aware of the potential losses that you can incur whether buying contracts or writing them.

Complexities of Options Trading.

The very nature of options trading and the complexities involved is a risk in itself. While it isn't really that difficult to understand the basics, some aspects of options trading and the strategies you can use are a lot more complicated. It's a fairly common mistake for investors, and particularly beginners, to not fully understand what they are doing and this can be a quite dangerous mistake to make.

You can overcome this risk by learning as much as possible, including the advanced topics, and only using strategies that you are completely familiar with. It's all too easy to second guess what you are doing and why, and this is something you should really try to avoid. Knowledge will give you confidence.

Liquidity of Options.

Options trading is far more common than it used to be, with an increasing number of investors getting involved, but there can still be some issues with liquidity of certain options. Because there are so many different types, it's quite possible that any particular option you wish to trade might only be traded in very low volume.

This can present a problem, because it may make it difficult to make the required trades at the right prices. It isn't a major issue if you are trading in very small volumes or only trading the most popular options, but for those trading large volumes or less mainstream options it can create additional risk. The exchanges typically use market makers to ensure certain levels of liquidity, but this doesn't necessarily remove the problem entirely.

Costs of Trading Options.

Closely linked to the liquidity of some options is the costs involved in trading them. The price of an options contract is always quoted on the exchanges with a bid price and an ask price. The bid price is the price you receive for writing them and the ask price is the price you pay for buying them.

The ask price is always higher than the bid price, and the difference between these two prices is known as the bid ask spread, or the spread. The spread is basically an indirect cost of trading options, and the bigger the spread the more those costs increase. A lack of liquidity will generally lead to bigger spreads, and this is another potentially significant risk.

The direct costs of trading options can also be higher than some other forms of investment: specifically the commissions charged by brokers. Such costs are an unavoidable part of any kind of investment, and should always be factored into any trading plan you prepare. The reason they are particularly relevant to options trading is that most strategies involve creating spreads.

Creating an options spread involves entering two or more positions on different options that are based on the same underlying security. There are very good reasons for creating these spreads, but the fact is that taking multiple positions effectively on a single trade does result in higher commissions.

Time Decay.

Another unavoidable risk is the effect of time decay. All options have some kind of time value factored in to them, and typically the longer they have until expiration the higher that time value is. Therefore, any options that you own will always be losing some of their value as time goes on. Of course, this doesn’t mean that they always go down in value, but time decay can negatively impact the value of any options that you hold on to.

You can read more about time decay here.

There are some investors that are aware of the risks involved in trading options and because of this they decide to avoid options as investment vehicle. The simple fact is that it isn't for everyone; it's a relatively unique way to invest and there are certain pitfalls and downsides.

However, no form of investment is without its disadvantages and there are also plenty of reasons why trading options is a good idea. There are certainly many investors who do make very good money from it and it's perfectly possible for anyone to do so. If you are considering getting involved, then your decision should really be based on whether the advantages of trading options outweighs the risks involved in your view.

If you do feel that trading options is for you, then the next thing you logically need to know is where you can buy, sell, and write options. For more information on this clearly important subject, please read the next page in this section: Where to Trade Options.

Option Trading Risks.

What Are Option Trading Risks?

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The option trading risks pertaining to options buyers are:

The option trading risks pertaining to options sellers are:

Other option trading risks mentioned are:

Option Trading Risks : The Offical Word In Short.

Option Trading Risks : 3 Macro Risk Factors.

Primary Risk (Market Risk)

Primary risk or Market risk is the risk that the overall market failed to move in your expected direction. If you are long calls on a whole portfolio of stocks then primary risk would be the risk that the market might crash, taking all your calls out of the money (OTM). In general, the more stocks and the more diversified the stocks that you invest in, the higher the chance that your portfolio will move as a whole closer to how the overall market is moving. Remember, the Dow that we know today is made up of 30 stocks. Buying shares or call options on these 30 stocks will give you a portfolio that moves exactly how the Dow is moving. This is a significant option trading risks if you are executing Long Call Options strategy across a wide portfolio of stocks.

Secondary Risk (Sector Risk)

Secondary risk or Sector risk is the risk that a whole sector of stocks failed to do well. There are times when specific market sectors do not do well due to fundamental economic reasons, causing all stocks in those particular sectors to crash. This is a significant option trading risks for option traders who executes bullish strategies on stocks from only a couple of sectors.

Idiosyncratic Risk (Individual Stock Risk)

Idiosyncratic risk is the risk that shares of a company you bought is effected by events that happens to that particular company. If you buy shares of XYZ company, you run the idiosyncratic risk of that company going bankrupt all of a sudden. This is an option trading risks that affects option traders who put all their money on the options of a single stock most.

Benefits & Risks of Options Trading.

You may be wondering - why would an investor want to get involved with complicated options, when they could just go out and buy or sell the underlying equity? There are a number of reasons such as:

An investor can profit on changes in an equity’s market price without ever having to actually put up the money to buy the equity. The premium to buy an option is a fraction of the cost of buying the equity outright. When an investor buys options instead of an equity, the investor stands to earn more per dollar invested - options have "leverage." Except in the case of selling uncovered calls or puts, risk is limited. In buying options, risk is limited to the premium paid for the option - no matter how much the actual stock price moves adversely in relation to the strike price.

Given these benefits, why wouldn’t everyone just want to invest with options? Options have characteristics that may make them less attractive for certain investors.

Options are very time sensitive investments. An options contract is for a short period - generally a few months. The buyer of an option could lose his or her entire investment even with a correct prediction about the direction and magnitude of a particular price change if the price change does not occur in the relevant time period (i. e., before the option expires). Some investors are more comfortable with a longer term investment generating ongoing income - a "buy and hold" investment strategy. Options are less tangible than some other investments. Stocks offer certificates, as do bank Certificates of Deposit, but an option is a "book-entry" only investment without a paper certificate of ownership.

Options aren’t right for every investor and are just right for others. Options can be risky but can also provide substantial opportunities to profit for those who properly use this very flexible and powerful financial instrument.

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