The Limitations of Trading Options

I’ve always been a fan of options trading. In fact, I still use covered calls as a tool in my investing arsenal. That being said, options, when not used correctly, can pose a serious amount of risk to the unknowing investor.

While options can be used as an effective tool for hedging and speculation, by nature they are highly complex and require a great deal of observation and attention. You have to be careful in not only predicting the movement of the market direction, but also the magnitude and timing of this movement.

A couple articles back I noted the advantages of trading options and how you can use them to increase your investment returns. This week, I’m going to go over some of the downfalls and risks that options bring.

Costs

Compared to trading stocks, the cost of trading options is significantly higher on a percentage basis and it can drastically eat into profits. The buyer of an option may end up losing the entire premium paid if he simply lets the option expire.

While the market may move in the direction anticipated by the buyer, it is important to remember that options have a limited lifespan and hence, the magnitude of the expected rise or fall in the share price may not justify the premium paid.

Unlimited Losses

When buying stocks, your losses are limited. If a stock hits $0, you’ve simply lost all of your investment. This isn’t the case when short selling stocks, but that’s a lesson for another time. Some option writing strategies can expose a writer to theoretically unlimited losses.

As mentioned in my previous options article, the writer of a call option may face the risk of unlimited losses if he is not holding the underlying asset at the time the contract expires. Assume that an option writer has sold a call option with a strike price of $50 and the market price on the date of expiration reaches $60 due to unforeseen circumstances.

In this case, if the writer is not holding the underlying shares, he will end up losing $10 per share, since he will have to purchase those shares at $60. This loss can increase substantially since there is no limit to how high a stock can go. This is where covered call writing can come into play, and can drastically reduce risk.

Liquidity

A buyer of an out of money call option can always sell the option before the expiration date to recover a portion of the premium paid instead of letting the option expire and losing the entire premium. However, it is important to remember that the liquidity of the option depends on the liquidity of the underlying stock.

For a holder of an illiquid option, it may be difficult to close their position before the expiration date in case the market moves against his predictions. An indicator of the liquidity of an option is the total number of option contracts currently open (Open interest).

While this number represents the number of options that have been traded, it does not specify the number of options exercised, sold or closed. Never the less, a change in the open interest indicates whether the trading volume is high or low. The larger the open interest, the more liquid the option.

Volatility

With an option being a derivative instrument, it depends on the price of the underlying shares that are attached to it. Also the option price is more volatile than the price of the underlying shares. An option that is in-the-money today can be out-of-money tomorrow due to unforeseen circumstances.

American Options Can Be Exercised Before Their Expiration Date

American options can be exercised at any time prior to the expiration date. The writer of an American option faces a risk of significant losses if he does not have the underlying shares at the time that the option is exercised. The writer should also be aware that certain events can trigger an early exercise of options.

For instance, the market price of a company tends to go down after the ex-dividend date and the holder of an American put option can choose to exercise their option at this point.

There are obviously more pitfalls of options trading, but these are 5 key factors you need to take into account before you start trading them. The easiest way to not go broke when trading options is to simply to gain the knowledge required beforehand. Learn the risky tactics and the safe ones and determine a risk tolerance level that is appropriate for you.

Set aside a certain percentage of your portfolio as “speculation” money and agree to never invest more than you have allotted.

Author Bio: Dan Kent is a writer and co founder of Stocktrades.ca. A DIY investor for 7 years now, Dan has a combination of dividend, growth and real estate investments in to his portfolio and is looking to continually grow his net worth. You can check his website out at stocktrades.ca or follow him on Twitter at @Stocktrades_CA.