The Top 10 Risks of Trading Options
Risk is a core element of trading in the Stock Market. When trading any security at any level, there is no way to avoid risk, but only the ability to manage and minimize that risk. Any professional trader would agree that risk management is a critical component of building a successful portfolio over the long-term. And within that, the art of trading options carries risks, just the same. It is critical to your trading success that you recognize and understand the most common risks that come along with trading options.
The first risk, and one of the most important, is the risk of losing your entire investment in a relatively short period of time. Options carry with them an expiration, and if you ride that option contract until the expiration date, losing your entire investment will be the byproduct. Along with that, is the fact that you can lose your entire investment BEFORE the expiration date, as the option goes further out-of-the-money (OTM). Without tending to your option contract, you are bound to wave your investment goodbye.
Option contracts have what are called exercise provisions. Just like with any contractual agreement, these are the rules, regulations, and limitations tied to the contract that the buyer must adhere to. With these provisions, come obstacles that create risk that is out of your hands and out of your control. The only control the buyer has is to either not purchase that particular option contract, or manage that position based on the provisions he or she is trading. Also critical, is the fact that regulatory agencies may impose exercise restrictions which may stop you from seizing certain opportunities and realizing value.
Now when it comes to selling options, there are also particular risks that come along with this side of the business. In perfect design, the relationship between an option contract buyer and seller should be always be mutually beneficial. But the inherent risk is the simple fact that options sold may be exercised at anytime before expiration, at the buyer’s discretion.
When it comes to selling different types of calls, there are risks and parameters that come along with each entry. Concerning selling covered calls, the risk lies in the fact that you forgo the right to profit when option’s underlying stock rises above the strike price of the call options sold. You then continue to run a risk when the underlying stock declines past your covered call income.
There will always be risk when dealing with selling naked calls and puts. The critical risk to note is that sellers of a naked call risk unlimited losses if the underlying stock rises and, inversely, that sellers of a naked put risk significant losses if the underlying stock drops. Sellers of naked positions also run “margin call” risks if the position yields significant losses. Such may include, but are not limited to, “subject to liquidation” by the broker. This is not fun and should be avoided at all costs!
A stipulation that may run a risk without the right strategy, is that as a seller of stock options, you are obligated under the terms of the contract to deliver the option they sold whether or not a trading market is available or whether or not they are able to perform a closing transaction. In that same context, is the fact that the value of an option contract (call or put) may surge or plummet unexpectedly when the underlying stock or security moves drastically, leading to automatic exercises and losses.
You cannot run from risk. With trading any security in the Stock Market, and of course trading stock options, there will always be risk brought on by the nature of the security and the risks brought on by your trading decisions. Of course, you can implement the various proven strategies to guide your trading, there is also risk in adhering to the complexities of these strategies. There is no way to avoid risk in the Stock Market, there is only to manage and minimize risk.
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