Those unfamiliar with options trading often have a totally skewed perception when it comes to the risks involved with this type of trading. Some view it as a virtually risk free vehicle to instant riches, while others steer clear of options because they view them as ‘exotic’ trading instruments with ‘unlimited risk’.
As we will see below, both perceptions are equally flawed. There are indeed risks involved in options trading, but if these risks are properly managed options trading can be a lower-risk vehicle than share investments or futures trading.
The correct way to approach the issue is by looking at both the risks and the rewards and to calculate the probabilities that each will become a reality.
Risks when buying options
When a trader purchases an option, the only way in which that trader can profit is if that option expires above the strike price. Below that level such a trader stands to lose his full investment. Fortunately this is limited to the purchase price of the option.
Many options buyers make the mistake of looking only at the profit/loss ratio of an option, without taking into account the probability of achieving that particular outcome.
Risks when selling options
The risk profile faced by an options seller is the reverse of that of an options buyer. If the options expire below the strike price, the options seller keeps the full amount of the premium received from writing (selling) the option.
Above the strike price of naked call options, the options seller faces unlimited risk to the upside – the risk is only limited by how much the underlying asset can increase in price up to the expiration date of the option.
Contrary to popular belief, the seller of naked put options does not face unlimited risk to the downside. His or her risk is limited by the price of the underlying asset – which cannot drop to a level below zero. From that loss should still be deducted the income derived from selling the put in the first place.
Risk versus reward – the full picture
Let us assume trader John has to decide whether to buy or sell a 1-month call option on company ABC shares. He has the following information at his disposal:
- The current price of ABC shares = $100
- The strike price of the option = $103
- The option is priced at $1.00
- Current volatility of ABC shares = 17%
Using an options probability calculator, trader John calculates that the option has a 24% probability of ending In the Money. If he should buy the option, he therefore faces a 24% probability of either breaking even or making a profit. He also faces a 76% probability of losing the money he spent on buying the options.
Selling the option would provide him with a premium of $1 per option (commissions excluded). There is a 76% probability that he will be able to keep this premium and a 24% probability that the option would expire in the money and he would therefore make a loss on
Options buyers therefore typically face numerous small losses followed by a couple of large profitable trades, while options sellers face many small profitable trades and a few big negative ones which, if not managed properly can wipe out their trading accounts.