In our introduction to options trading we have already provided a detailed explanation of what options are and what trading them entails, along with an overview of all the advantages. If you are seriously considering this form of trading as part, or all, of your investment strategy, then these basic topics are important to know.
It's also advisable that, before you actually get started, you also understand some of the downsides to trading options and the risks involved.
With any form of investing, your capital is ultimately at risk to some degree as soon as you invest it, and options trading is no different. While there a number of ways that you can limit your risk, through using the appropriate trading strategies for example, there are certain direct and indirect risks that you really should be aware of. On this page, we provide further details on this, covering the following:
- Potential Losses
- Complexities
- Liquidity
- Costs
- Time Decay
Potential Losses in Options Trading
One of the many reasons that investors choose to trade options is due to the flexibility and versatility they offer, and the wide range of strategies that can be used. In particular, there are a number of strategies that can be used to either limit the risk of taking a position or reduce the upfront costs of taking a position.
With some of the limited risk strategies, it's possible to enter a trade and know exactly what the maximum potential loss is, which can be very useful when planning trades. However, options trading is widely considered to be high risk and it's certainly possible to make significant losses. Obviously, the more you learn and the more experience you get the less likely you are to make catastrophic losses, but even experienced traders can make mistakes and it's important to know what sort of risks you are exposed to.
A major advantage that is often mentioned is the fact that you can use leverage to effectively multiply the power of your capital. For example, if you bought $1,000 worth of call options based on Company X stock then you could stand to make much bigger profits. If that stock went up, then you should directly invest that $1,000 into the stock.
However, the flip side to this is if the stock fell in value, or even just remained the same, your call options may end up worthless and you would lose your entire $1,000. Had you bought the stock instead, you would only lose all that $1,000 if Company X went bankrupt. This highlights a major risk, that it's possible for options that you buy to expire worthless, meaning you lose anything you invested in those contracts.
Equally, when writing options, you can possibly lose large sums of money if the underlying security moves dramatically in price in an unfavorable direction. There are steps that you can take to limit losses, such as using stop loss orders or creating spreads, but it's vital that you are aware of the potential losses that you can incur whether buying contracts or writing them.
Complexities of Options Trading
The very nature of options trading and the complexities involved is a risk in itself. While it isn't really that difficult to understand the basics, some aspects of options trading and the strategies you can use are a lot more complicated. It's a fairly common mistake for investors, and particularly beginners, to not fully understand what they are doing and this can be a quite dangerous mistake to make.
You can overcome this risk by learning as much as possible, including the advanced topics, and only using strategies that you are completely familiar with. It's all too easy to second guess what you are doing and why, and this is something you should really try to avoid.Knowledge will give you confidence.
Liquidity of Options
Options trading is far more common than it used to be, with an increasing number of investors getting involved, but there can still be some issues with liquidity of certain options. Because there are so many different types, it's quite possible that any particular option you wish to trade might only be traded in very low volume.
This can present a problem, because it may make it difficult to make the required trades at the right prices. It isn't a major issue if you are trading in very small volumes or only trading the most popular options, but for those trading large volumes or less mainstream options it can create additional risk. The exchanges typically use market makers to ensure certain levels of liquidity, but this doesn't necessarily remove the problem entirely.
Costs of Trading Options
Closely linked to the liquidity of some options is the costs involved in trading them. The price of an options contract is always quoted on the exchanges with a bid price and an ask price. The bid price is the price you receive for writing them and the ask price is the price you pay for buying them.
The ask price is always higher than the bid price, and the difference between these two prices is known as the bid ask spread, or the spread. The spread is basically an indirect cost of trading options, and the bigger the spread the more those costs increase. A lack of liquidity will generally lead to bigger spreads, and this is another potentially significant risk.
The direct costs of trading options can also be higher than some other forms of investment: specifically the commissions charged by brokers. Such costs are an unavoidable part of any kind of investment, and should always be factored into any trading plan you prepare. The reason they are particularly relevant to options trading is that most strategies involve creating spreads.
Creating an options spread involves entering two or more positions on different options that are based on the same underlying security. There are very good reasons for creating these spreads, but the fact is that taking multiple positions effectively on a single trade does result in higher commissions.
Time Decay
Another unavoidable risk is the effect of time decay. All options have some kind of time value factored in to them, and typically the longer they have until expiration the higher that time value is. Therefore, any options that you own will always be losing some of their value as time goes on. Of course, this doesn’t mean that they always go down in value, but time decay can negatively impact the value of any options that you hold on to.
You can read more about time decayhere.
Summary
There are some investors that are aware of the risks involved in trading options and because of this they decide to avoid options as investment vehicle. The simple fact is that it isn't for everyone; it's a relatively unique way to invest and there are certain pitfalls and downsides.
However, no form of investment is without its disadvantages and there are also plenty of reasons why trading options is a good idea. There are certainly many investors who do make very good money from it and it's perfectly possible for anyone to do so. If you are considering getting involved, then your decision should really be based on whether the advantages of trading options outweighs the risks involved in your view.
If you do feel that trading options is for you, then the next thing you logically need to know is where you can buy, sell, and write options. For more information on this clearly important subject, please read the next page in this section:Where to Trade Options.
