Option trading can be a wonderful way to get more bang for your investing buck. But with those benefits comes some risks that are not found in other types of trading vehicles.
Buying options instead of owning an equity outright allows the investor or active trader the opportunity to control more of the underlying asset for a fraction of the cost.
For example, if you were to buy 100 shares of stock XYZ at say $30 a share, you would have to pay $3000 (plus commissions) to control that amount of stock.
On the other hand, if options are available for that stock, where each option being for 100 shares of stock (the standard for regular options), you would be able to purchase that option for just a fraction of owning the stock outright, and control the same number of shares.
The risk with buying options as opposed to buying the asset outright is that ownership does not expire, options do. Options are very time sensitive, and each day that goes by causes the option to lose some of its ‘time value’, which is a part of the premium you pay for the option.
Therefore, you could hold onto a stock indefinitely, but you cannot do the same with options as they will expire come expiration day. With buying options, you are in essence ‘buying time’ for that stock to make enough of a move in your desired direction to not only overcome the time loss but to also make a profit.
Why would anyone want to take a risk of having their investment become worthless in a matter of weeks or months?
Using our current example, suppose the premium to purchase an option of stock XYZ with 60 days left costs $3.00. At 100 shares represented, that would be $300 to purchase. Let’s also say that the option purchased is a 30 strike (at-the-money since that’s the current stock price).
If XYZ moves up to $40 a share, the owner of 100 shares of XYZ has made $1000, as that is $10 a share times 100 shares. That is a return of 33.3%. Not bad.
The owner of a 30 strike Call option (call options appreciate when price of underlying asset goes up) also makes $10 times 100 shares or $1000, but does so for only a $300 investment. That’s a return of 233%. That’s leverage!
However, if price does not move up enough before expiration, the buyer of the option can lose 100% of his investment (in this example $300) and have nothing to show for it, while the stock owner still owns the stock (although that isn’t risk free either, since the value of the stock may be lower than when purchased).
Options can be used to minimize risk in other investments based on strategies used to buy or sell them against other assets. They can be quite complicated to set up and not for the inexperienced. Failing to understand the risks of option buying and selling can result in devastating losses overall. But applied correctly, options can be one of the lowest risk trading vehicles for traders of all account sizes.