The Risks of Option Trading

Option trading has a reputation of being capable of high returns and impressive profits, but also carrying with it higher than normal risk – risk that makes many traders and investors wary of using options at all. I think there are risk concerns, but it’s not just about risk – it’s about the rewards you can gain from taking on that risk.

Options trading has a lot of potential, and can deliver higher returns than other types of trading. But, it also carries with it higher levels of risk, on average, than other types. 

Here, I’ll give you an overview of options trading, including explaining what risks are in play when you trade options and whether or not those risks are justified by the return you can potentially earn.

A Brief Summary of Options Trading

First, though, we’ll explain exactly what options trading entails. There are several types of options out there, and each one has a different risk profile.

When people first see the term ‘options trading’, most think of stock options, as in the option to purchase a stock at a given date at a given price. Stock options are not just for employees as a part of a compensation package; they are also heavily traded and can give investors the option to make money without leveraging all of their capital and purchasing stock directly.

For example, if you buy an option contract for, say, Apple, you are purchasing the right to buy Apple stock at a later date. You pay something called a premium for this right – but you don’t have to actually exercise the right.

Let’s say you buy a call option, which gives you the right to purchase Apple at a strike price of $500 per share by the end of the month. At any time during the next month, you can exercise your right. Let’s say you pay $3,000 as a premium. Most options contracts are for lots of 100 shares. So, you’re looking at buying 100 shares of Apple at $500 per by the end of the month.

What happens if Apple’s share price is higher than $500? Let’s say it is $550. You would make a profit of $50 multiplied by 100 shares, minus your premium, or $2,000.

If Apple’s share price is lower than $500, you simply would let your option expire and only lose your premium of $3,000.

That is a standard options contract scenario. You can also buy binary options, which pay you if your asset’s value is above (or below) a certain strike price when the options contract expires. They’re called binary options because there are only two possible outcomes: you finish in the money and receive 70-90% of your initial investment, or you lose everything.

Examining Risk

On the surface, it appears that standard stock options aren’t as risky as buying stock itself. Indeed, with a standard, vanilla contract, you’re only going to lose your premium (because you have no obligation to actually purchase shares.)

Of course, it is easy for options to expire and become worthless. All that has to happen is for the asset in question to never rise above the strike price during the contract’s time period. Or, if you’re selling options, the stock rising above the strike price means you lose money.

With binary options, the risk is even more profound. You have a very real chance of losing your entire investment. Let’s say you buy a binary option for Apple stock with a strike price of $500, and an expiry on January 1, 2013. You spend $5,000 on this option, and purchase a call option – meaning you think the price will be above $500 when the contract expires.

If Apple’s price is, say, $499 on January 1st, you’d lose your entire $5,000 – and you’d only stand to gain 70-90% of $5,000 if you were correct. While that’s a huge amount of profit for one trade, you’re still risking everything to win less than everything.

The possibility for 100% investment capital loss is a daunting one for some traders, which is why many stay away from binary options. But, binary options can generate the kind of one-time returns in a relatively-quick manner that is unequalled by virtually any other trading service.

Are Options for You?

It’s easy to say that options trading is too risky when you only look at the risk. You also have to look at the return, as well as how much you can leverage your capital to produce a return.

Evaluate your risk profile. If you feel comfortable putting all of your money up for grabs to win a big, one-shot return, then binary options could be for you. If you’d rather leverage your capital without the sky-high risk of binary options, standard options may be for you.

See also:

Risks in Futures Trading

Hedging with Options and Futures

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