Risks of Options
There are basically two types of risks: the ones beyond your reach, and the ones you can control or limit. With regard the first category it’s worth noting that, contrary to popular belief, options were initially created for defensive purposes and not for offensive plays. As a matter of fact, options (the purchase of puts to be precise) were primarily designed to address the main risk that investors cannot control but are exposed to: market risk.
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However, it’s worth noting that other options strategies, that do not involve the purchase of puts for hedging purposes, can leave you exposed to market risk (including the indirect and negative impact of macro-economic and geopolitical factors). This situation may appear no different than owning stocks, bonds, or mutual funds, except that you can greatly reduce the impact of beyond-your-reach market risk by applying specific options strategies (and related risk management techniques). We explain these in our free educational section of this website.
So, now let’s address those risks you can directly control, limit, or even eliminate. What are they exactly?
Lack of Education
Maybe you’ve applied the wrong strategy given the circumstances; entered or exited the position at the wrong time; or failed to adjust a trade when necessary? In short, you haven’t made the most informed decision due to a lack of knowledge and now your strategy might backfire. Proper education is key. It will be your primary tool in managing the risk of using options effectively. While success cannot be guaranteed, a lack of education will assure you sub-optimal performance.
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Lack of Consistency
Educating yourself about financial options is indispensable but not sufficient. You need to also be able to apply your knowledge appropriately and within the right context. You can only achieve this through practice and time. So, let patience, perseverance, and resilience be on your side. In practice this means dedicating sufficient time to the proper set up of your trades, the monitoring and post-execution analysis.Lack of Preparation and Behavioral Mishaps
One of the primary conventions of financial theory holds that market participants will make decisions to try to maximize their wealth in a way that is as rational as possible. However, the relatively new field of behavioral finance has demonstrated that there are many instances when presumed reasonable market players are deeply influenced by their emotions and can end up taking irrational and detrimental decisions. To mitigate this risk, you must have a plan at the outset and apply it diligently. The starting point is to define your overall approach, clarify your mindset, and address some key questions:- Are you positioning yourself as a trader (short term view, time works against you but less capital intensive) or as an investor (long term view, time is on your side but more capital intensive)?
- What is your objective: generating weekly/monthly revenues? Increasing your capital? Protecting your portfolio? Investing in new stocks and diversifying your portfolio at a discount vs current market price?
- What is your risk profile: conservative? Opportunist? Aggressive?
- How much can you afford to lose (i.e. determine your capital at risk)?
- What options strategies do you favor?
- What is your outlook on the market and of each position you are considering for trading?
- What are your primary and secondary exit points?
- What risk management techniques are you going to use and at what point (time indicator vs price indicator for instance)?
Preparation is critical not only for your overall success but also to reduce any potential psychological turmoil that is likely in times of large market movements whether down (FOL – fear of loss) or up (FOMO – fear of missing out).
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Sequencing Risk
Sequencing risk (also called sequence-of-returns risk) is the risk that the order and timing of the returns on your option trades is unfavourable and ultimately lead you to give up on an opportunity to let the overall strategy play out. We will teach you how to address this risk, particularly through trade size management. If you give up because your first set of trades did not work out the way you hoped for, you will never be able to fully enjoy all the advantages that options have to offer.Leverage Risk
While leverage represents a distinct advantage in options trading, it can be treacherous for the uneducated trader. In experienced hands, leverage can significantly increase the rate of return, and/or be used to speculate with less risk than owning the actual underlying stock. However, an option seller can incur losses much greater than the price of the contract, if the trader has not implemented a rigorous approach to his trade setup.
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Limited Time
Contrary to stocks, options expire (they are “wasting” assets). This can work to the advantage of option sellers as the passing of time will increase the value of the options sold (all else being equal). However, option buyers seek to capitalize on a price movement that must take place within a limited time for the trade to play out. Long-term stock investors have theoretically unlimited time to let their investments profit.Additional Costs
Some options strategies (like selling calls on securities you don’t own) require you to set up a margin account (i.e., a line of credit provided by the broker that serves as collateral in case the trade moves against you). Margin loan interest rates can run into the double-digit range, so you need to use caution when trading on margin. The broker may also issue a margin call, requiring that you add more funds into the account to cover any shortfall within a very tight deadline. If you are unable to make good on the call, the broker can automatically liquidate some positions or even your whole account as deemed necessary by regulation or internal policy.
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The Option Expert does not provide investment advice. No statement on this website is to be construed as a recommendation to purchase or sell a security, nor to provide investment recommendations. Options involve risk and are not suitable for all investors.