Lesson 13 – Options Main Risks and Key Risk Management Principles

Lesson Objective: Learning the main risks of options and the key risk management principles to mitigate such risks

Key Benefits of Trading Options

First, let’s start by reiterating the key reasons why we believe options are overall less risky and more profitable than owning stock (or even more diversified ETFs) when used properly:

  1. Higher chance of success: with stocks you typically have a 50/50 chance of being right on the direction at the time of entry (we will discuss this concept in a later module). Trying to pick the direction of a stock is incredibly hard for the average trader but with options we don’t need to trade the underlying stock or ETF to be profitable. With options, you could enter into a position with an expected “beat-the-market” return and an initial 70% chance of winning (or possibly higher). You are able to choose your starting point as well as the trade-off between the return, the probability of success, and the risk profile of the trade (in line with your sentiment/views).
  2. Flexibility: you can use options to create any strategy you desire and align it with (1) your financial goals (including preserving your existing capital, generating monthly income, or building up a well-diversified portfolio) and (2) your risk appetite (be it conservative, moderate, or aggressive). Options have 6 moving parts (factors) as discussed in lesson 10 on options pricing, so you can also play with these to fine-tune your strategy.
  3. Adaptability: you can change your initial set-up to adjust to new market conditions and still win. You can reposition the risk profile of your entire portfolio almost instantly (when the market is open for trading) so that it meets your new sentiment about a stock, a sector, an industry, or even a whole country without even having to sell any of your existing positions. This ability to adapt so quickly is virtually impossible in other parts of the investment world such as real estate, mutual funds, physical gold, or other commodities.
  4. Risk Management: because of the adaptability of options, and contrary to popular belief, they are often a safer alternative to owning equity.
    1. Options are actually the most dependable form of hedge, and this makes them safer than equity. Let’s take the most often used case of stop-loss orders that appeal to many equities’ investors. The stop order is designed to cut losses below a predetermined price. The problem lies in the fact that the stop order is executed when the stock trades at or below the limit, which could happen very suddenly and abruptly.
    2. For example, let’s say you buy a stock at $50. You do not wish to lose any more than 10% of your investment, so you place a $45 stop order. This order will become a market order to sell at any price once the stock trades at or below $45. This order will not protect you against any sudden large drop (“gap risk”). Let’s say there are rumors of embezzlement and the stock goes down to $20 overnight or even in a matter of minutes. When that happens, $20 will be the first trade below your stop order’s $45 limit price. So, you will automatically sell at $20, locking in a 60% loss!
    3. Had you purchased a $45 put option for protection, you would not have suffered the catastrophic loss. Unlike stop-loss orders, options do not shut down when the market closes and provide protection 24/7. Not only that, but they also protect you from the very first dollar below the strike price you chose ($45 in the example above). This is why options are considered a reliable form of hedging.
    4. This is just one example; because options have so many moving parts, they can be used in infinite ways to control and manage risk the way you intend it.
    5. You may even be able to win whether the underlying stock moves up, down or sideways in a given range. In some cases, when the initial trades go your way, you can enter new trades to lock gains regardless of where the underlying goes afterwards.
  5. Leverage: with options, the capital requirement is typically much less than for stocks so options are more cost efficient: you can enter an option position substantially similar to a stock position (a strategy known as stock replacement) but with less investment.
    1. For example, to purchase 100 shares of XYZ stock at $50, you must pay out $5,000. However, if you were to purchase one $15 call option (representing 100 shares), the total outlay would only be $1,500 i.e., 100 shares x the $15. You would then have an additional $3,500 left in your account which could either be used to generate interest or be applied to another investment opportunity, i.e. providing a diversification.
  6. Higher Returns: Thanks to the leveraged nature of options, since you spend less money (than buying an equivalent amount of stock) and make basically the same profit, you can achieve a higher rate of return.
    1. Going back to the $50 XYZ stock example above, let’s say you buy a call option with a delta of 80, meaning the option’s price will change by 80% of the stock’s price change. (Delta is one of the “Greeks”, a concept which we will cover in a separate module). If the stock were to go up $5, your stock position would provide a 10% return. On the other hand, your option position would gain 80% of the stock movement (due to its 80 delta), or $4. A $4 gain on a $15 investment amounts to more than a 25% return—much better than the 10% return on the stock. Of course, when the trade doesn’t go your way, options can also amplify your losses and you may forego 100% of your investment. That is the reason why you always need to have a risk management plan as well as an exit plan before you enter a trade. This will almost guarantee that you never lose 100% of your investment.
  7. Accessible to smaller accounts: The leveraged nature of options also means that you can start with a smaller account and quickly grow it if you manage to implement successful strategies. But again, it’s a double-edge sword, so always consider the trade size guidance we advise below along with our other risk management techniques.
  8. Scalability: with options, you can add to a successful strategy in a matter of seconds. Assuming you bought one $50 call and the stock moves up and you believe the trend will continue, you can immediately scale up by buying one, or two, or several more contracts once the trend is confirmed. Replicating this strategy with stocks would be more capital intensive. In other businesses (like owning a store or restaurant) scalability is significantly reduced. You can also go the opposite way and lessen your exposure rapidly.

However, these advantages may also be the source of potential drawbacks that cannot be dissociated (just like the two sides of a coin). It is important for you to understand the key risks that exist when trading options and how to best address these concerns.

Key Risks of Trading Options

A. Risk of Entering a Trade Not Aligned With Your Sentiment and/or Beyond Your Means

The first advantage/risk trade-off relates to point 1 above (“higher chance of success”). You first need to realize that there is always a trade-off between risk and return in options trading (as with any other financial instrument). You could well decide to position your trade in an attempt to realize an aggressive return but your probability of success would be quite remote and you would likely be required to commit more capital in doing so.

Suppose you want to sell one of the two puts below on the company named Intuitive Surgical at a time when ISRG trades around $560 (Mar 1st 2019). You can either go with:

a) ISRG 29 Mar 2019 $540 Put for which you would receive a $6.40 premium (per share).

This option is OTM since the strike is below the current ISRG share price, so the intrinsic value is zero and the entire value of the option is made up exclusively of extrinsic value: $6.40. So, what you are essentially buying here is time (and hope)!

Your broker’s calculator will tell you that the probability for any profit in this trade is 78% while the probability for maximum profit ($640) is 73% (you cannot make more than the premium received, which happens if the option expires OTM). Your maximum loss is $53,360 [(strike – premium received) x 100 shares] equivalent to a risk/reward ratio of 1:0.01 ($640/$53,360). Note that the breakeven point is at $533.60 ($540 – $6.40).

Finally, your maximum (annualized) return on investment is 16% ([(1+(6.4/533.6))^(365/29)]-1) if the option finishes OTM, not bad in comparison to the average performance of the market!

Or,

b) ISRG 29 Mar 2019 $580 Put for which you would receive a $24.60 premium (per share).

This option is obviously deep ITM: $20 of intrinsic value ($580 – $560) representing 81% of the total premium (the option is said to be “rich”), which explains why it is so expensive – you are receiving a lot of intrinsic (“real”) value. In comparison to the previous option, the extrinsic value here represents only 19% of the total price instead of 100%.

Here, your broker’s calculator will tell you that the probability for any profit in this trade is 60% while the probability for maximum profit ($2,460) is 30%. Your maximum loss is $55,540 [($580 – $24.60) x 100 shares], so a risk/reward ratio of 1:0.04 ($2,460/$55,540). Your breakeven point is at $555.40 (strike – premium).

Finally, your maximum (annualized) return on investment is almost 73% ([(1+(24.6/555.4))^(365/29)-1]) if the option finishes OTM, an amazing potential performance, far better than that of the market…

As you can see, the second option has a much higher potential return (73%) in comparison to the first one (16%) but this maximum return is far less likely (30% chance vs. 73% chance) – hence the trade-off you are facing between risk and return. Your choice!

Overall the risk/reward ratio is better for the second option (4 times better than the first one), but it could cost you almost $2,000 more than the first scenario if your option contract was ITM at expiration thereby obliging you to buy 100 shares of ISRG.

In fact, neither scenarios are good or bad trades. It all depends on what your sentiment and views are and what you can afford (your “risk appetite”) at the time of entry.

If you are bullish on ISRG and firmly believe that it can jump at least 3.57% (i.e., from $560 to $580) between Mar 1st and Mar 29th (which would turn option b from being ITM into being OTM) then you should probably choose option b) and select  the $580 strike provided that you also have $55,540 (the net outlay as calculated by strike-premium) set aside in case you are assigned the option. If you are right, you would get an excellent return.

On the other hand, if you are uncertain of the direction ISRG will take in March and believe that it might go up, move sideways, or even go down a little (but not below $540), then you would be better off with option a).

So, our first risk-management rule here is two-fold: 1) always enter a trade with a risk/return profile that matches your views on the underlying. 2) make sure that you can afford (be prepared for) the “worst-case” scenario, e.g., if you sell a put you must have enough funds set aside to buy the underlying in case you are assigned the option; if you sell a call you either need to have the shares on hand to deliver in case of assignment (you sell a “covered call”) or you need to have sufficient funds to meet any margin requirement from your broker in the case of a naked call.

B) Risk of Not Having A Clear Understanding of The Key Components of The Option Traded

The second advantage/risk trade-off has to do with bullet point 2 (“flexibility”). Because options are comprised of six moving parts, they do provide significant plasticity and can adapt to any bespoke strategy you need or want.

It is essential however, that before trading any option you have a clear picture of where each of these 6 factors stands and that you understand how any change in one (or more) of them would affect the value of your option.

As a reminder, the six factors are:

  1. the underlying’s current trading price
  2. the option’s strike price
  3. Prime interest rates
  4. Dividend yield of the underlying
  5. the maturity/expiration date of the option, and finally,
  6. the implied volatility (“IV”) of the underlying

Remember that the last one listed here (IV) is merely a reflection of the general market sentiment on the underlying (as measured by its supply and demand). If IV is high (in comparison to its historical levels), then it means that the market expects the price of the underlying to vary more (than usual) in the future.

Now, if you decide for instance to buy a call option on underlying XYZ (because you’re bullish) and are not aware that its IV is at an all-time high, you might be paying too much considering the likelihood of IV mean-reversing as discussed in Lesson 10.

Don’t forget that the price of an option is positively correlated to its IV, meaning that if IV increases, the option’s price will increase as well (all else being equal). So, if you buy an option for which the underlying’s IV is already high and therefore, will more-likely-than-not return to its lower historical level, you are stacking the odds against yourself. Should the IV decrease over the life of your option, indeed you may need a significant move of your underlying upward to compensate for the fall in volatility, and that might not be enough.

Another risk scenario would be to trade an option on an underlying for which you are not aware of the existence of a dividend or of an upcoming ex-dividend date. We tackled that concept in Lesson 12 on exercise and assignment of options but let’s reiterate with an example.

Assume you sold a one-month call option on stock XYZ and failed to note that the lifetime of the option comprised the next ex-dividend date on XYZ (the corresponding dividend that was announced was $0.60). Four days before expiration, you receive an assignment notice that you did not expect because the stock price is barely above the strike price (“At-the-Money”) so, you go and check your broker’s screen and see that the extrinsic value is still worth $0.40. You wonder: “How come the option holder decided to exercise his/her option and forego 40 cents per share?” That’s because in doing so s/he can get a 60-cent dividend instead, so s/he doesn’t care about the remaining 40 cents of extrinsic value. That would be a benign mistake if you had the shares available in your account but could be a costly one if you were going to wait until the last minute to cover your naked call.

Usually, options’ holders do not exercise options until they are getting close to expiration due to the significant extrinsic value still built into the overall value of the option. One exception is when the value of the dividend (which the holder could capture by exercising their right before the ex-dividend date) supersedes the remaining extrinsic value; in this case  the exercise of the call option would make economic sense.

Our second risk-management rule, as illustrated by the examples above, highlights the importance of fully understanding how the six factors of an option could affect its value It is key for you to study their impact before entering a trade.

C. Risk of Overreacting or Reacting Too Soon (or Too Late)

The third advantage/risk trade-off relates to bullet point 3 (“adaptability”) and trading behavior.

In comparison to equity traders, most options traders usually have a shorter-term perspective (especially if they trade “weeklys”, i.e., options with an initial 8 day-life), which may lead them to react to macro-economic or idiosyncratic news too soon rather than letting their options work their way through the noise.

Often times, news – especially if they are not stock-specific – will initially impact an underlying up or down but the move will then fade away after a couple of days or weeks. If you change your views too soon, you may hurt your position and end up being worse-off than if you had been a little patient and not over-reactive.

This concept applies to both

(a) the fear of missing out, sometimes called “FOMO”: e.g., you may be entering a trade too early out of fear that you will miss a significant opportunity. Think of all the people who invested in Bitcoin in December 2017 when everyone and every media were talking about it as being the next investment phenomenon. Had they waited a few more months they would have realized December 2017 was the worst time possible to invest in Bitcoin, and

(b) the fear of losing money, whereby you exit a trade too early out of fear that you may lose it all. Think of all the people who sold their positions in late 2008 or early 2009 when everyone else was panicking – basically the worst possible time as the market was bottoming. Had they waited a few more months they would have captured a significant recovery.

Our third risk-management rule is to distinguish between real/valuable information (which may require you to adjust your trades) and market “noise” before trading on the basis of such news; and to avoid behavioral mistakes such as the herd mentality which could lead you to trade for the wrong reasons.

D. Risk of Too Much Leverage Given Your Risk Tolerance

As mentioned in the 5th bullet point at the start of this module (“leverage”), the leverage attribute of options can create unpleasant consequences if the trades don’t go your way and are not well managed.

When you own 1 share of a $100-stock and your share goes down 10%, you have an unrealized loss of $10 only.

If you own 1 option contract such as a call on the same stock and your contract goes down 10%, you have an unrealized loss of $1,000 because 1 option contract is generally quoted for 100 shares (so, 100 shares x $100 x 10%)!

The contract could lose 10% of its value for a number of reasons: a) your option is very deep in-the money and the underlying goes down 10%, or b) your option is slightly ITM and the underlying only goes down 5% but significant time has elapsed, or c) the underlying does not move but time and volatility have both decreased significantly, etc. Therefore, many possibilities could trigger a leveraged move in the value of your option and you have to be prepared for them.

Our fourth risk-management rule is to enter small trades for any given underlying – this way a significant move in the option’s value will have a limited impact on the overall value of your portfolio. We usually recommend trades for which the maximum loss or margin requirement (per your broker) is no more than 10% of the overall value of your portfolio. Size consideration is a key element of sound risk management as you never know which way the market is going to move.

Our fifth rule relates to cash balance.  We recommend holding enough cash (20% to 60% of your portfolio value) so that you can afford to be assigned stock when required and/or stand ready to enter more trades if the market sells out and offers interesting opportunities to buy any underlyings at “discounted” prices.

Finally, our sixth rule relates to either (1) trading a portfolio in which the diversification (in terms of non-correlated underlying assets) matches your risk appetite (e.g., you’re trading underlyings in sectors that you prefer and for which you don’t mind the exposure), or (2) trading positions that are going to behave as a natural hedge to one another to some extent (bearish vs. bullish), or (3) using options themselves to hedge some of your portfolio. For instance, you could consider different underlyings in different industries and asset classes, such as bonds, equity, real estate, commodities, etc. Diversification is the only free lunch in the investment world as it doesn’t cost you or anyone else anything. It is also easy to implement. As far as we are concerned, we usually prefer to overweight some sectors such as technology (when we feel the right conditions are met) and use offsetting positions or options (such as in the case of married puts) to limit the risk to the downside.

In subsequent lessons, we will also explain why we usually prefer to be options sellers rather than options buyers (although we do buy options within the context of multi-leg, more complex strategies, rather than merely buying outrights calls or puts). While being an option seller is not viewed as a risk management technique per se, it can provide an edge compared to being an option buyer that will be worth discussing.

error: Content is protected !!