Last updated on February 11th, 2022 , 07:23 am
When you’re trading stocks, your only true risk is directional. If you’re long a stock, your risk is that this equity will down in value. If you’re short a stock, your risk is this equity goes up in value. As long as the markets are “liquid”, these are the only true risks in stock trading.
Options trading, on the other hand, introduces traders to a myriad of risks.
In order to understand the risks of derivatives, we must first understand what, exactly, options are. If you already know these basics, please skip ahead directly to the 5 risks of options trading.
TAKEAWAYS
- Call options are leveraged bullish market bets; put options are leveraged bearish bets.
- Options are decaying assets. An options time decay, or “theta”, refers to the rate at which an option price declines as time passes in a constant environment.
- Implied volatility risk occurs after major events, such as earnings and economic data.
- Dividend risk applies to short call positions and occurs in the days leading up to the “ex-dividend” date.
- Pin risk occurs when the price of a stock/ETF is trading very close to the strike price of an option in the moments leading into expiration.
- Memory risk is perhaps the most important on our list. Options traders must remain diligent.
Options Trading Explained
An option is a financial instrument that allows an investor to place leveraged bets on an underlying security. This exposure can either be on the upside or downside. Options can also be used as vehicles to hedge, but this article is going to focus on options as financial instruments of speculation, as this is how most investors employ them.
One option contract almost always represents 100 shares of stock. This great leverage introduces great risks.
There are only two types of options; call options and put options. Call Options are “bullish” bets while “put options” are bearish bets. Let’s next examine each one of these contracts closer.
Call Options Explained
Call Option Definition: A call option is a contract that gives an owner the right, but not the obligation, to purchase 100 shares of a stock at a specified strike price on or before an expiration date.
Call options are bullish. If you believe a security will go up substantially in value, a call option can offer you:
- More profit/loss potential than stocks
- Less principle risk than stocks
Let’s say AAPL is trading at $170 per share. You think, that by next month, the price of AAPL will surpass $180 dollars. Let’s take a look at the details of an options trade that would profit should AAPL exceed $180 in one month.
Here are the details of our trade:
AAPL Stock Price: $170
Call Strike Price: 180
Call Price: $3 ($300)
Expiration Date: January 17th (30 days away)
So we paid $3 for this call option. You will recall earlier we mentioned that one option contract represents 100 shares of stock. Though the quoted price of this option is $3, we actually paid $300 for it.
Let’s fast forward 30 days now to expiration and see how our trade did!
Call Outcome #1: Maximum Loss
So let’s say a month has passed. We were wrong. AAPL is trading at only $179. Of course, it went up in value; but not enough for us. In this scenario, since the stock price did not reach our strike price by the expiration date, our call will expire worthless.
This 180 strike price call gave us the right to purchase AAPL stock at $180 per share by our expiration date. Since the stock is trading below this price, why in the world would we exercise our right to purchase the stock at a higher price? We wouldn’t. Therefore, our trade results in a maximum loss of $300.
Call Outcome #2: Profit
In this scenario, let’s say AAPL rallied all the way to $185 in value on expiration day. How did we do?
A lot better! Our 180 strike price option is “in-the-money” by $5 here. So did we make the difference of $500? Not quite. Remember, we paid $3 for the option to begin with. Therefore, this $3 must be subtracted from our $500 profit. To determine our net profit, we simply subtract this premium paid of $3 from the amount the option is in-the-money by ($5), giving us a net profit of $2. Taking into account the multiplier effect, this $2 would represent $200 in profits.
Could we have made more than this? Sure! Since there is no cap on how high a stock can go, a long call has infinite profit potential.
Put Options Explained
Put Option Definition: A put option is a contract that gives the owner the right, but not the obligation, to sell 100 shares of a stock at a specified strike price on or before an expiration date.
Everything we learned of call options is true of put options, with one major difference: put options bet on a downward move in the stock.
Let’s take a look at that same trade, but this time we think AAPL will be trading not at $180 in one month, but $160, making us bearish. We will therefore buy a put option.
Here are our trade details:
AAPL Stock Price: $170
Put Strike Price: 160
Put Price: $3 ($300)
Expiration Date: January 17th (30 days away)
Put Outcome #1: Maximum Loss
So let’s say the 30 days have passed and our put option is expiring. AAPL is trading at $165 on this date. Our put option gives us the right to sell 100 shares of AAPL at $160 per share.
When you sell a stock, you want to sell it for as much value as you can. Therefore, why would you sell stock at $160 per share when the current market value is $165?
You wouldn’t. Therefore, this 160 strike price put option will expire worthless, and we will lose the entire $3 ($300) premium we paid for it.
Put Outcome #2: Profit
In this scenario, let’s say AAPL fell all the way to $152 on expiration day. Our 160 strike price put is therefore in the money by $8 ($800).
But did we make $800? Not quite. Remember, we need to subtract the debit paid from this amount. We paid $3 ($300) for this option, therefore we will see a net profit on this trade of $500 ($800-$300).
In a nutshell, these are the basics of options contracts. If you’d like a complete lesson, please check out our video, Options Trading for Beginners below. 12 million views and counting!
Let’s now take a look at some key risks in options trading. Bear in mind that these are only a few of the more salient risks: options trading has dozens of them!
1.) Time Decay Risk
Options, unlike stocks, have a lifespan. They are decaying assets. If you buy a 180 call on a stock that is trading at $175, and in a week from now the stock price hasn’t changed, your call option will most likely go down in value. This is assuming implied volatility hasn’t changed.
Why will it go down? Because as time passes, the odds that that stock has of reaching your strike price have diminished. This is known as “time decay”.
Professional options traders rely on a set of risk management metrics called “The Greeks” to mitigate risk. There is indeed a Greek pertaining to time decay, and it is called “theta”.
Theta tells us how much an options contract will go down over the course of a day should all else (stock price and implied volatility) remain the same. The below table shows us how this Greek interacts with a long call position.
| Type | Strike | Price | Theta |
|---|---|---|---|
|
Call |
147 |
3.25 |
-.52 |
|
Call |
148 |
2.63 |
-.56 |
|
Call |
149 |
2.11 |
-.54 |
For each day that passes, in an environment where all else remains constant, the theta values above tell us how much each corresponding option will decline in value.
So time decay is indeed a risk to option buyers; but what about option sellers? If you buy an option, somebody has to sell you that option, right? Traders’ short options love time decay, because, unlike option buyers, they want that option to go down in value.
2.) Volatility Risk
An option’s value is comprised completely of extrinsic and/or extrinsic value.
Intrinsic Value Definition: In options trading, the intrinsic value represents the value of an option should that option be exercised at the moment of observation.
Extrinsic Value Definition: In options trading, the extrinsic value represents all option value that is not intrinsic value.
So what, exactly, comprises extrinsic value?
- Time Decay
- Implied Volatility
We just learned above about time decay. Let’s now explore the other half of extrinsic value – implied volatility. This metric also happens to be our next options trading risk.
All options have assigned implied volatility. This figure tells us the expected move of an underlying security over a certain time frame.
In addition to different stocks having different implied volatility levels (IV), the different expiration cycles within each stocks options chain have their own unique IV levels, as illustrated on the tastyworks trading platform below.
Implied Volatility per Expiration
If a company is to release earnings in the days ahead, this will probably cause the stock to either go up or down more in value than on a normal trading day. Because of this, events like earnings (or even economic news) can jack up IV levels.
Guess what happens after the news is released? Bingo. The IV levels (usually) drop. This is referred to as “volatility crush” and is a great risk to long options traders. When the IV of a specific options expiration goes down, so does the premium of all options listed under this expiration.
Just like with time decay, this is a negative for long option positions but a positive for short options.
3.) Dividend Risk
Dividend risk applies to all short call option positions on a dividend issuing security.
Owning stock comes rights. One of these is the right to share in corporate profits via dividends. Options, however, have no such rights. Therefore, sometimes, it makes sense for a long call to exercise their right to purchase stock before a dividend is issued to collect this dividend. This poses a risk for short-call positions.
In the time leading up to the “ex-dividend” date, assignment risk on short in-the-money calls can rise.
If the value of the issuing dividend exceeds the value of a short call option, dividend risk is indeed present.
4.) Pin Risk
Pin Risk Definition: Pin risk arises when the price of a security is trading very close to the strike price of an options contract at the moments leading up to expiration.
A lot can happen in the moments leading up to an options expiration.
Let’s say we are short the AAPL 170 call while AAPL is trading at 169.50. It is the day of expiration and there are only 2 minutes left in the trading day.
At the moment, we are safe. As long as AAPL stays under 170, we will remain safe. But what if, in the last two seconds of trading, a wave of buy orders comes in, sending AAPL to $170.15?
Our option is in-the-money, and the markets are closed. So what can we do? Not much. We will probably be assigned on our short call, and forced to sell 100 shares of stock. We could hedge this risk by buying 100 shares, but there is no guarantee that we will be assigned. This is a messy situation and can result in huge monetary losses.
To eliminate pin risk, close out of any short at-the-money options before the bell rings. It’s that simple.
This risk can be present in long options too, but long options can inform their broker to NOT exercise their contract. This is assuming the trader is paying attention. This brings us to our next risk.
5.) Memory Risk
After working in the retail options industry for 15 years, I can tell you the greatest of all risks comes from individual traders’ negligence.
Options trading requires diligence. There are a lot of moving parts in this business. You have to stay on top of your game at all times. The “set it and forget it” mentality does not work in options trading.
If you tend to be forgetful, make it a habit to set reminders for important upcoming events, such as “earnings calls” and important expiration dates. If you are habitually forgetful, options trading probably isn’t for you. There are simply too many risks!
Final Word
This list is by no means exhaustive. For example, “liquidity risk”, just like in stocks, is present in options. You want to make sure there is sufficient volume in a stock before placing an options trade on that stock. Additionally, the bid-ask spread should be tight.
Hopefully the above list will get you started on understanding the risks of options trading.
A lot of money can be both made and lost in options trading. It is always best to start small and slowly increase your positions as you become more comfortable.
All new traders eventually make a mistake. However, it is far better for this mistake to involve a one-lot than a one-hundred lot!
