Understanding the Basic Risks of an Options Trader
August 6, 2007
Many new options traders are sometimes under the impression that it is far less risky to be a purchaser of options than being a seller. However, this is not always the case. In this article we will try to clear up some of the common misunderstandings relating to the various risks involved in options trading.
First, traders are typically told that purchasing options involves limited risk and the trader cannot lose more than the premium paid plus commissions and fees. While this is indeed true, when consistently done incorrectly, the rate at which the trader can lose their risk capital is unlimited.
Another often-overlooked but important thing to keep in mind is that the option purchaser is not the only one with limited risk. There is also a limited risk to the option premium writer that the buyer will ever have the ability to exercise their option and actually cash in. This is based on the statistical fact that 80 to 90 percent of all options sold expire worthless.
Remember that an options buyer, in order to profit from the trade, must be correct about two things involving the price of the underlying stock. First, the option buyer must be right about the direction of the price. Second, the option buyer must be right about when the direction will change. If the price of the underlying stock does not move sufficiently in the anticipated direction before the option’s expiration, the options buyer will lose all or most of their investment.
On the other hand, the options writer only has unlimited risk if the trader sells naked options and never does cover this nakedness. There are numerous options writing strategies like covered writing, bull put spreads, bear call spreads, iron condors as well as other combinations that can be employed that limits or caps the risk.
As a trader, it is important to understand the risk differences from being a buyer versus being a seller. It is not always best to be a buyer because there are numerous situations that call for being a net seller of premium. This is why it is paramount to understand the risks of each position and how to combat those risks to be a profitable options trader. Always match the strategy to the opportunity, whether it calls for being a seller of premium or being a buyer of premium.
Jeff Neal
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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