Talk about risks. One of the notable things that most
people would commonly say about option trading, or other
types of trading for that matter, is that it entails
risks. A lot of them. Some of them are discussed in this
article.
First off, any trade, in fact almost anything that
promises much profit surely carries with it lots of
disadvantages. You only get what you pay for. As they
say, you don’t get free rides. When you give more then
you would most likely get more. The same principle works
with the trade. With higher promise of profit come
higher and greater risks to be taken.
So what makes option trading a high risk venture? It’s
definitely the leverage. Leverage, in trade speak, is
one of those crucial things that could make or break
your trade. It gives you the advantage while taking away
your potential profit if you pick the wrong option or
the wrong timing to trade. Leverage is so attractive
that it is among the things that make people want to
enter trading but it is also disadvantageous when not
properly used. In the case of options trading, there is
higher leverage offered. Depending on which side of the
coin you look, leverage could either mean boon or doom.
As defined in its financial sense, leverage is a
relatively small amount of money you invest in something
that could turn out big. Sounds pretty interesting but
what’s the problem? Just like what was mentioned
earlier, a higher leverage could mean higher loss of
profits if the trade is mishandled.
Apart from these, risks of options trading can be seen
from two different perspectives—the buyer’s risks, the
seller’s risks.
Buyer’s risks
Options trading offer the possibility of losing your
entire investment in a relatively short period of time.
It is noteworthy that the main essence of options
trading is to control a certain asset within a certain
period of time at a fraction of the asset’s original
price. So if you bought an asset that has an expiration
of 3 months and within those months the stock remains at
a certain price lower than what is profitable, then you
could really lose all your investments very fast. Losses
compound as the expiration date approaches.
This is the main reason why traders who are interested
in this type of trading are advised to participate only
with their risk capital.
Further, European style option, a classification of
options trading, restricts its traders to exercising the
option after the expiration date since it does not offer
secondary markets. Also, there are certain option
contracts that may further create risks as well as
regulatory agencies that could limit the possibility of
realizing the value of a certain option.
Seller’s risks
Option trading is also risky for the sellers. There are
types of options that may have unlimited possibility of
losses depending on the movement of the underlying
stock. There are also occasions when even if there are
no trading markets, sellers are obligated to sell
options.
All the risks involved in options trading should be
understood as something inherent to it. But any trader
should not take the risks as the hook, line and sinker
of the trade. As we have mentioned earlier, more risks
mean better profits. So you should put into your
calculation the risks but you must not forget the profit
you could get from option trading.