Options: Risk vs. Return

Weighing the risks 

Complexity and volatility are part of the options market. For this reason it’s important to fully understand the risks associated with options trading before using these strategies in your portfolio. To begin learning about these products, please read Options Basics.

Compared to buying (or selling) stock, options are highly leveraged investments with a potential for relatively high returns. This is because a change in the price or volatility of the underlying security can cause a large swing in the price of the option. The effect is magnified because the lower price for options can increase (or decrease) faster percentagewise for every $1 rise (or fall) in the stock price (more on that below).

Long positions in options (call and put buyers)

If you’ve bought a call or a put, the risk is defined. The most that you can lose is your investment (the premium you paid for the option) plus commissions.

Options have a short shelf life, though, so the strategy you put in place may have limited time to work. If the price of the underlying stock does not move above the strike price (in the case of a call option) or below (in the case of a put option) before the contract’s expiration date, it will expire worthless.

It’s also important to note that unlike owning stocks, options pay no interest or dividends and have no voting rights.

Short positions in options (call and put sellers)

When selling (writing) calls or puts, the most you stand to gain is the price at which the option is sold (the premium you receive), less commissions. 

If you own a stock, and you’re selling a call on it (a strategy called covered call writing) there is a risk that your stock may be “called away”. As the call writer, you are obligated to sell the stock to the call buyer at the exercise price if the call buyer decides to exercise the right to buy the stock. This would most likely happen if the stock price is above a call option’s strike price (option is in-the-money) and the contract is near or at its expiration date. A sale of your stock may not be what you anticipated.

If you don’t own the underlying stock, and you are writing puts and calls, a strategy known as "naked options", it is particularly risky. There is a potential for unlimited loss if you write a naked call option and if you write a naked put, the greatest loss would be if the stock value went to zero. These strategies are complicated and are used by advanced investors who understand and accept the risks.

Be mindful of the sage words of Warren Buffet – “Risk comes from not knowing what you're doing”.

Using Leverage

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

Example; you purchase 10 call options on ABC stock (representing 1,000 shares) with an exercise (strike) price of $9 per share. The current price of ABC is $10, with a market value of $10,000. If you exercised your right to buy the stock at the option’s exercise price, it would cost you $9,000 (1000 x $9). The difference between the market value of the stock and the option’s exercise price is called its intrinsic value (or in-the-money $ value). In column A, this would be $1,000.

If the market price of ABC increases 10% to $11 per share, the market value of the stock increases to $11,000. The exercise price remains fixed, but the option’s intrinsic value doubles from $1,000 to $2,000 (see column B below), an increase of 100%.

	A	B
	$10/share	$11/share	% Change
Value of stock	$10,000	$11,000	10%
Exercise cost	($9,000)	($9,000)	0%
The Option’s Intrinsic Value	$1,000	$2,000	100%

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

	A	B
	$10/share	$9/share	% Change
Value of stock	$10,000	$9,000	-10%
Exercise cost	($9,000)	($9,000)	0%
The Option’s Intrinsic Value	$1,000	$0	-100%

Column B shows what would happen if the market price of ABC decreased 10%, from $10 to $9 per share. The market value of the stock decreases to $9,000 but the option’s intrinsic value falls to $0, a 100% decline.

Options can be high-risk instruments, so it’s important to closely monitor your investments and recognize how much risk you have in a position or your portfolio at any given time.