Managing the risks of options trading

There are risks with any trading, and options are no different.

However, properly used, options can help cap your risks. In fact, when you are buying options, your risk is limited to the premium paid for the option, no matter how much the underlying market price moves adversely in relation to the strike price.

However, when selling options the risk can be much greater, and in theory is unlimited – as we’ll explain below.

It is therefore important that you understand exactly what the risks are.

Buying an option

When buying an option – either call or put – your maximum risk is equal to the premium paid. This is simply calculated as trade size multiplied by price. When you buy a put or call option, you have no obligation to follow through on the trade. If your assumptions were incorrect, your losses are limited to whatever you paid for the contract and trading fees.

Potential profit is unlimited when you buy a call, as the option payoff will increase along with the underlying asset price until expiry, and there is theoretically no limit to how high it can go. When you buy a put, your possible profit is limited only by the underlying asset’s value falling to zero.

Buying options is therefore limited-risk, with a potential profit that is in theory uncapped if you buy a call.

Risk/reward: your potential loss from a bought option is limited to the premium paid. Buying options is therefore limited-risk.

Selling an option

However, it is also possible to sell an option, and the risks are very different.

Selling an option is obviously the reverse of buying it.

When you sell options, you receive the premium rather than pay it. So when you write (or sell – they mean the same thing) a put or call, you are obliged to buy or sell at a specified price within the contract’s timeframe, even if the price is unfavourable.

This could mean a loss.

When you sell a put, the worst-case scenario is that the price of the asset falls to zero.

But when you sell a call, things could get really difficult. Because in theory, if the price of an asset should rally, there’s no cap on how high it can rise – so there could be no limit on your loss.

Risk/reward: if you’re selling an option, your maximum profit is equal to the premium you received, but your maximum risk is unknown.

Other things to consider before trading options

These are the main risks, but there are some other factors to consider before you make a decision about options:

Complicated market
Options are flexible, but they can also be complicated. Instead of buying an asset in the hope that its price will increase, you have to factor in how much its price will increase and when the movement will occur. There are measures – known as the Greeks, explained later in the course – which can help you understand the way an asset has moved in the past.

Of course, these provide no guarantee of what it might do in the future. There is no substitute for knowing the market and the factors that are affecting particular assets.

Price volatility
The premium you’ll pay to buy an option is dependent on more than just the price of its underlying market – so before you start trading options you’ll need to learn what moves options prices. As we explained in the previous lesson, an option’s price – meaning the premium that you pay to buy the option – will change depending on several different factors. The most important are the level of the underlying market compared to the strike price, the time left until the option expires, and the underlying volatility of the market.

All of the factors work on the same principle: the more likely it is that an option will move above (calls) or below (puts) its strike price, the higher its premium will be.

Time decay
A significant part of an option’s value will often come from the remaining time it has before it expires. This value will diminish as it draws closer to expiring, making options extremely time-sensitive.

Question

Question 1

When you buy a put the risk is:

• a Unlimited
• b Limited to the premium
• c Equal to the value of the underlying asset

Reveal answer

Question 2

When you sell a call the risk is:

• a Unlimited
• b Limited to the premium
• c Equal to the value of the underlying asset minus the premium

Reveal answer

Question 3

When you buy a put the potential profit is:

• a Unlimited
• b Limited to the premium
• c Equal to the difference between the strike and the value of the underlying asset minus the premium

Reveal answer

Lesson summary

• It’s important to understand and keep in mind the risks of options trading
• When buying an option the risk is restricted to the premium you pay. If the market does not move as you anticipated or you do not use the option, your premium will be lost
• When selling an option, the risks can be unlimited
• There are some key factors affecting options prices to consider, including the complications of the market, the volatility of a particular asset and the effect of time – known as time decay