Option Trading Risks

Simplified Version / Comprehensive Version

You must have heard things like "Option trading is risky" or "option trading is a high risk investment vehicle" before, right? So what are option trading risks? What kinds of option trading risks are there? Can we really go broke in option trading? We will attempt to explore and answer these questions and more on this page.

What Are Option Trading Risks?

In fact, what is the meaning of risk in the stock markets? Risk is defined as the probability of loss of trading capital. In layman terms, it means the odds of losing money. Option trading has been deemed risky mainly because of the possibility of leveraged loss of trading capital due to the leveraged nature of stock options. Many forms of option trading risks can lead to catastrophic losses. A complete understanding would certainly help option traders last much longer in the options market.

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Option Trading Risks : The Official Word

To explore what option trading risks are, we start with the most authoritative document : The Characteristics and Risks of Standardized Options by the CBOE (Chicago Board Of Exchange). Please download and read the document Here. Here, we shall explore some critical elements in that document pertaining to option trading risks.

The main chapter that explains option trading risks in the Characteristics and Risks of Standardized Options document is at "Chapter X" (chapter 10 but X sounds really cool, doesn't it?), which classifies these risks based on options buyers, options sellers (writer) and other risks. We summarised each of these option trading risks specific to stock options below.

The option trading risks pertaining to options buyers are:

1. Risk of losing your entire investment in a relatively short period of time.

2. The risk of losing your entire investment increases as the option goes out of the money (OTM) and as expiration nears.

3. European style options which do not have secondary markets on which to sell the options prior to expiration can only realise its value upon expiration.

4. Specific exercise provisions of a specific option contract may create risks.

5. Regulatory agencies may impose exercise restrictions, which stops you from realising value.

The option trading risks pertaining to options sellers are:

1. Options sold may be exercised at anytime before expiration.

2. Covered Call traders forgo the right to profit when the underlying stock rises above the strike price of the call options sold and continues to risk a loss due to a decline in the underlying stock.

3. Writers of Naked Call Write risk unlimited losses if the underlying stock rises.

4. Writers of Naked Put Write risk unlimited losses if the underlying stock drops.

5. Writers of naked positions run margin risks if the position goes into significant losses. Such risks may include liquidation by the broker.

6. Writers of call options can lose more money than a short seller of that stock on the same rise on that underlying stock. This is an example of how the leverage in options can work against the option trader.

7. Writers of Naked Call Write are obligated to deliver shares of the underlyng stock if those call options are exercised.

8. Call options can be exercised outside of market hours such that effective remedy actions cannot be performed by the writer of those options.

9. Writers of stock options are obligated under the options that they sold even if a trading market is not available or that they are unable to perform a closing transaction.

10. The value of the underlying stock may surge or ditch unexpectedly, leading to automatic exercises.

Other option trading risks mentioned are:

1. The complexity of some option strategies is a significant risk on its own.

2. Option trading exchanges or markets and option contracts itself are open to changes at all times. The availability and conditions of which are not to be taken to be permenant.

3. Options markets has the right to halt the trading of any options, thus preventing investors from realising value.

4. Risk of erroneous reporting of exercise value.

5. If an options brokerage firm goes insolvent, investors trading through that firm may be affected.

6. Internationally traded options have special risks due to timing across borders.

Option Trading Risks : The Offical Word In Short

As we can see above, the Characteristics and Risks of Standardized Options clearly explains all the possible risks related directly to the buying and selling of stock options comprehensively. The option trading risks factors listed are extremely detailed and "micro" in scope, surrounding a few basic themes. They are :

1. Naked options positions has unlimited loss potential.

2. Options can expire out of the money and worthless. (thus all the money you put towards purchasing them)

3. Options leverage can work against you as much as it can work for you.

4. Obligations and rights of buyers and sellers.

5. Terms, conditions and policies of the specific option contract, options exchanges or options brokers can change at anytime.

Every of the above option trading risks can result in a catastropic loss of capital, that is why you must fully understand stock options as a financial instrument so that you can lower the option trading risks posed by the above.

Like a car race, the risk that you will lose the race is more than how the car is made and manufactured. There are more option trading risks factors that can lead to a capital loss than these direct reasons. These are what we call "macro" risks.

Option Trading Risks : 3 Macro Risk Factors

There are 3 macro risk factors which applies to any investments on the stock market and are not option trading specific. They are known as Primary risk (market risk), Secondary risk (sector risk) and idiosyncratic risk (individual stock risk). Option trading risks are closely related to stock risks as stock options are a derivative of stocks. Therefore, it is paramount to understand these risk factors in order to better understand option trading risks.

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.

As you can see from the above, there is no way to totally eliminate option trading risks. If you hedge against Primary risk by buying options of only a few stocks, you increase secondary and idiosyncratic risk. If you hedge against idiosyncratic risk by buying options of more stocks in the same sector, you increase secondary risk. This fact, along with the leverage effect of stock options, makes option trading a riskier investment vehicle than simply buying stocks.

Option Trading Risks : Directional Risk

Perhaps the next most signficant option trading risks that affects most option traders is Directional Risk or Delta Risk. No matter what option strategies you choose to execute, the underlying stock needs to behave in the manner needed for that particular option strategy to turn a profit. For example, if you execute a Bull Call Spread on XYZ company's stock, then that stock needs to rise before you can turn a profit. If your prediction is wrong, you can still lose money. Directional risks can be hedged using Delta Neutral Hedging.

Option Trading Risks : Other Less Significant Risks

Apart from the Delta Risk mentioned above, option traders also face other option trading risks such as gamma risk, rho risk, vega risk and theta risk. All of these risks are represented by the option greeks and can be hedged away using spread strategies.

Option Trading Risks : Conclusion

Yes, option trading is risky and you can lose all your money through option trading and there are plenty of reasons to prove it. However, option trading can also be safe if you know how to hedge your position properly, choose option strategies that profit from more than 1 direction and use leverage smartly. Option trading risks is a fact that all option traders need to live with and keep in mind at all times just like we never forget how dangerous cars can be when we cross every road. Even though option trading can be risky, there are situations and reasons why stock trading can be riskier than option trading. Please read How Stocks Can Be Riskier Than Options.

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