Risks of Options Trading

Among all the ways one can trade in financial securities, options trading particularly stands out as the risks involved, and is widely believed to be the riskiest form of trading.

There is at least some truth in that belief, although it really depends on how one is using options, and in particular, how skilled one is at trading them.

In most cases with options trades, there isn’t anything particularly risky with them, provided that you know what you are doing, using them to take positions in an underlying security for instance versus just trading that security directly. Where the two strategies tend to differ the most where risk is concerned is the added difficulty in being successful with options trading, versus most other forms of trading, and perhaps versus all forms of it.

There are three main strategies with options, with the first being to use them as a hedge. In this case, the options trading reduces overall risk rather than adding to it, so we cannot even say that options used for this purpose are risky at all.

As long as the hedges are used properly, buying options for hedging will yield less risk than just doing nothing, not hedging in other words. Within this strategy there may be some plays that are riskier than others but the overall effect is risk reduction.

So,  we cannot even speak of this means of using options as having any risk, because when we speak of risk we mean adding to risk.

The other two main strategies with options are in buying options and in selling them, and both of these do involve a certain degree of risk, but how much does depend.

Risks of Buying Options for Speculation

A lot of people look at buying options as either hitting them or losing everything, and when they look at the number of options that hit and find it’s only about 10%, that sure sounds like this is a deal where you stand to lose all of your money 90% of the time.

Risks of Options TradingThat sure seems pretty risky, especially to people who get concerned when their portfolios of the underlying asset go down a fairly modest amount, say 10% or 20%.

This is a modest drawdown for long term stock market investing thought, and it’s fairly common to see things go further than this during a pullback. There’s actually quite a bit more risk present in long term investing than people think, and this is risk that really cannot be managed very well without looking to time markets, which is not what long-term investors look to do.

There are options traders that this sort of risk would really scare, and there are plenty of traders that just being in a position overnight in a market that closes would scare the daylights out of them, exposing them to the risk of a gap against them at the open which they can’t manage.

With this said, a lot of options traders do broke, and often do so several times, so the risk of losing all the money in your account is going to be higher for sure with options than it is with buying and holding stocks for instance.

Where the Risk from Buying Options Actually Comes From

The reason that they are exposed to this risk doesn’t really have much to do with the structure of options itself, as even if they do lose all of what they paid for an option contract, this isn’t any different than setting a certain risk level with any sort of trade.

If you buy a stock and set a stop at a certain amount, this is what you are risking in a trade, and the cost of the option is similar, only you know for sure that you won’t lose any more than this, and also don’t have to worry about putting in the right stops.

Many traders struggle with this and often find themselves setting their stops too tight, and getting out of trades they should have stayed in, or setting them too loose and losing more than they should, when the correct time to exit the trade would have been at a higher price.

So the fact that you may lose your entire premium is not the issue really, no more than any other trade stopping out for you would be. Traders don’t have to lose the entire premium either, and they will often actually trade the options like you would any other security, entering and exiting at selected times to show a profit on the option trade itself.

In this case you will need to use things like proper entries and exits, including well placed stops, but in all cases, if you sell the option, you got something back.

This makes options trading just like any other sort of trading as far as the buying and selling of the securities goes, with the added benefit of having your maximum loss capped at the cost of the option. Given that you will only be using a small percentage of your overall options account on any given trade, it should not be that difficult to manage these risks.

However, a lot of traders do not manage risk that well when dabbling in options. The good options traders do, and that’s why they are able to do this over the long term.

Risk Often Comes Down to Risk Management

It is fair to say that the added risk where options buying is concerned is all due to not the risk itself, but how well it is managed. This is true as well of options sellers, where the risk involved is potentially much greater than with buying options, but these risks can all be managed and need not ever be high risk.

When it comes to options buyers, the biggest risk is the fact that they may not be skilled enough to have a positive expectation in the first place.

If this is the case, the risk of failure isn’t just great, it’s certain, unless one turns things around enough before they go broke or have their account beat down so much that it cannot recover over any reasonable time even in the hands of a very skilled trader.

If you lose 75% of your trading funds for instance, this not only does not bode well as far as the chances you’ll be able to somehow turn profitable quickly enough, but even if you do, you now need to triple your portfolio just to get back to where you started. This is possible, but of course difficult given that it takes some real skill to pull that off.

So, unless an options trader has achieved the level where they have the expectation of a reasonable rate of return over time, they need to trade accordingly, which means taking the most minimum of positions, or even better, to paper trade until they get to the point where they should be betting with real money.

This is not what a lot of people do though, they crave the excitement of real action, they dream of big profits, but if this is not grounded in reality, it will just remain a dream.

Proper trade sizing is one of the most important variables in trading anything, and what people don’t always realize is that unless you have shown that you can make money trading something, the proper size of your trades should be zero dollars and zero trades,

It’s possible though that some traders might derive some excitement or entertainment value from trading options with real money, and people do gamble a lot with a negative expectation anyway, so this is not unusual.

If so, they should look to limit their losses to what they are willing to risk, and realize that things might not go so well at all, so this limit needs to be placed both on trades and on the total amount that they are committing to their trading account. Just like we need to prepare for losing the entire premium with an option, unproven options traders need to prepare for losing their entire account.

Turning the Corner into Profitability

If one does achieve a positive expectation, it is just as important to manage risk, and in this case what we’d be looking at is looking to limit our exposure to the market overall at any one time.

This includes both making sure that we don’t commit too much to each trade, as well as looking at not taking on too many trades either. If we’re buying calls for instance and the market is in decline overall, we may lose most or even all of the bets we have out there, as this is not an environment that sees many things exceeding their strike price.

There are other things that people can do with options to limit their risk exposure on the buy side, and you can buy other options with cheaper premiums for instance which could serve to hedge your main positions.

This is how people hedge naked options selling, which is seen as the most risky sort of position you can take with securities, but it’s only a naked if you truly take a naked, meaning unhedged position, and there are other ways to hedge these besides having a position in the underlying security to cover things.

Whether you are buying or selling options though, if you don’t know whether or not your ideas and skills are profitable, they probably are not. If you are looking to get into trading options and you are an unproven trader, it’s best to at the very least tread very carefully and look to manage your risks as well as you can.

If you’re looking to sell options and are unproven, you really better make sure that you know what you are doing, but few traders venture into this without the proper experience. Some do though and even writing covered calls should never be undertaken without a full understanding of the implications of this, including the risks.

Part of the risk here, and the part that escapes some people, is the risk you’ll give up the profits you would have earned on the stock if you did not sell the option, and that can be significant.

Overall, while options can certainly be risky, and very often they are, the risk with options can be pretty well managed, providing one has a positive expectation, an expectation of something else other than just headed toward going broke over time.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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