Understanding the Risks of Trading Options

With options trading, it's important to be mindful of the sage words of Warren Buffett: "Risk comes from not knowing what you're doing."

Options can be high-risk instruments, so it's important to closely monitor your investments and understand how much risk you're taking on at any given time.

Let's look at some of the risks that can come with options.

Long positions (call and put buyers)

If you buy a call or a put, your risk is defined. That's because the most that you can lose is your investment — or the premium you paid for the option — plus commissions.

Short positions (call and put sellers)

When selling (writing) calls or puts, the most you can earn is the premium you get for selling the option, less commissions.

In the case of selling naked calls, which means you don't own the underlying stock, there is risk of unlimited loss since there's no limit to how high a stock's price can go. Selling naked puts is also risky, but there is a maximum loss that can be reached, which is if a stock falls to zero. Both are considered advanced options strategies.

With covered-call writing, which is when you own a stock and you sell a call option on it, there is a risk that your stock may be "called away" by the buyer of the option. As the writer, you are obligated to sell the stock at the strike price if the call buyer decides to exercise the right to buy it. This would most likely happen when the call option is in-the-money — when the stock price is above the strike price — and the contract is near or at its expiry date. Nonetheless, a sale of your stock might not be what you anticipated.

Options and leverage

Depending on the type of option and underlying asset, there can be many nuances, rules and differences to keep in mind. Options are highly leveraged investments with the potential for relatively high performance returns, but it's important to understand that the options market is both complex and volatile.

A change in the price or volatility of the underlying asset (such as a stock or index) can cause a large swing in the price of an option. The effect is magnified because the lower price of an option can increase or decrease faster, percentage-wise, for every $1 rise or fall in the asset price (more on that below). In this way, options can allow you to greatly multiply the power of your starting capital, though it doesn't always work out that way.

Let's look at how leverage can work in your favour or against you, depending on the situation.

Let's say you buy 10 call options on company ABC (representing 1,000 shares), with a strike price of $9 per share. The current price of company ABC's stock is $10, with a market value of $10,000. If you exercised your right to buy shares at the option's strike price, it would cost you $9,000 (1,000 x $9). The difference between the market value of the stock and the option's strike price is its intrinsic value (or in-the-money value). In this case, that would be $1,000 (column A below).

Now let's say the market price of company ABC increases to $11 per share, for a market value of $11,000. The strike price is still $9, so the option's intrinsic value (the difference between market value and strike price) is now $2,000 (column B). So, the value of the underlying stock rose 10%, while the option's intrinsic value jumped 100%.

Leverage also works in the opposite direction and can magnify your losses.

In the second table, column B shows what would happen if the market price of company ABC decreased 10%, to $9 per share. The market value of the stock decreases to $9,000, but the option's intrinsic value falls too, for a 100% decline.

Remember those words wise Warren Buffett. And be sure to study the details of the type of options you are interested in before using them as part of your investing strategy.