All investments carry risk. Putting your money in a sock and burying it has risk of being lost, stolen, or losing value at the inflationary rate. Money kept in the bank only earns at current interest rates which fluctuate, and the possibility exists that the bank could collapse. Although the risks are somewhat low in this example, the rewards are likewise comparative.
What sorts of risks are associated with options trading?
Leverage Works Both Ways
If the asset rises 10 percent, your option could double. If the asset drops 10 percent your contract could also shed 75 percent of its value. This represents the two-edged sword of leverage – it can work for or against you. The amount of leverage you get with an option largely depends on the fundamental factors built into the premium as discussed earlier, as well as how far ‘in the money’ your option is. The further in you go, the lower the risk and the less leverage you have.
Although, the most you can lose, even if leverage goes against you, is the amount you paid in options premiums.
Naked Option Writing
Options written against stock that is held is termed covered call writing. The option writer has an asset or a position in the market that can back up his option thus limiting his risk.
When a trader writes options without having a market position to back it up, this is called naked option writing. The potential for his losses is uncapped or limitless. Even some option spread strategies have unlimited risk, particularly if the spread transaction results in a net credit (referred to as credit trading where money is made by the transaction itself).
Options Decay over Time
If you purchase options, these will slowly lose value over time which is known as Theta. If the stock stagnates and trades sideways, your option will slowly lose any extrinsic value. If the option is ‘out of the money’ the contract will expire worthless in someone’s portfolio.
The options purchaser needs to be realistic in picking an appropriate time frame for the expected move. Picking short term options carries higher risk.
Changes in Option Fundamentals
The option is at risk to a host of factors that make up the fundamental value in an options contract. If interest rates drop, this will lower the options premium. If the market turns from being very volatile to calm, option values will also decrease. If the market expectation changes from bull to bear, you may also see the premiums drop with call options. This is also referred to as the negative effect of cooling implied volatility.
Problems with Liquidity
A thinly traded stock will usually have thinly traded options. Other illiquid options are ones that are very far in or out of the money that may have little investor interest. This can create a liquidity risk. Illiquid options may cost more than fair value when purchasing. As well, when it comes time to sell, there may not be an overwhelming supply of buyers. This could lead to some options being traded at a very poor price or expiring worthless even though some intrinsic value existed.
Problems with Margin
If a person were to buy on margin, this would open himself up to additional risk. Options are already leveraged, and buying on margin would create an even greater leverage. However this margin would need to be funded with additional capital if the trade went against you. Failure to add funding when margin call occurs could lead to a loss of the position altogether.
However, most option traders do not purchase this already leveraged product with more margin. CFD’s are more common for buying on margin.
Of course, there are a variety of other unforeseeable risks that could occur such as your computer breaking down, the ASX experiencing problems and halting a trade, or some other issue that could negatively impact your options trading. You need to be aware that trading on an electronic exchange may produce some financial hiccups.