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The Risks of Options

By Edited Jun 21, 2014 0 2

If you're becoming familiar with investing in securities, then you've probably heard about the awesome earning potential you have can achieve by trading stock equity options. What many newer investors don't take into consideration is the associated risks of options, and the chance all of their investment can be lost because of these risk. Options are very speculative investment vehicles that can provide you with limited risk, and unlimited reward potential, if used correctly.

Options: The Attraction & The Risks

Many investors are attracted to the leverage that options offer, and the small amount of money that it takes to purchase a contract that controls 100 shares. But, when you consider that you can lose your entire investment if your contract closes out of the money, then they may not be the best option for you to invest in. Options do not always move in correlation with the price of the underlying stock because there are many factors that affect the price of the contract. Things such as time value, the volatility of the underlying stock, the risk free rate, the dividend rate, whether it is in or out of the money, and the price of the underlying stock all come together to determine the price of the option.

There are tools available that will help you to determine whether the current price of the option is over or undervalued such as the Black Scholes model and the Greeks, but in the end it's all just speculation. It can be frustrating to see that you picked the correct direction of the price of the underlying stock, but you're completely wrong on the price of the option. If you do begin trading options, be prepared for the frustration…it's the nature of the beast.

So, if you can lose all of your investment in options, how you take the benefits of the leverage that they offer, but not risk everything? The answer is to not invest all of your available funds into options. I would consider anything more than 10% of your total investment funds to be high. I really wouldn't recommend that you begin actively trading options unless you have a minimum of about $10,000 that you can afford to trade with. The reason for the high sum is the cost of commissions and drawbacks. You don't want to be out of the game too soon. 10% of $10,000 will give you $1,000 to invest in options.

If your commissions are $10 to buy one contract and $10 to sell that contract, then you have to earn at least $20 just to break even. Or, you can let it expire worthless in which case you lose all of your investment + the commission. These aren't exactly good odds, and if you're using proper money management techniques, then you probably won't be buying more than one contract if you don't have at least $1,000.

As you can see, unless you have a broker that has very low commissions, you really need to trade multiple option contracts just to beat the commissions. That is why it's important to have enough funds to purchase multiple contracts, while not putting too high of a percentage of your overall trading funds at risk.

My First Experience Trading Options

Years ago I had fell into the trap of seeing only the profits that options could provide, and believed that I would be one of the fantastic stories of a person investing a few hundred dollars, and instantly becoming a millionaire. I studied technical analysis, and as much as I could about options. My run was nothing but frustration as I watched my funds diminish (mostly because of commissions). I just kept throwing my money in, and finally couldn't afford to buy anymore contracts. My account was blown, and I had to save up to begin again. I was sure that I was doing everything correctly, but it was the market not acting right. Looking back, I was foolish, and in no way prepared to trade options.

As years went by my impulsive nature has diminished, and my trading philosophy has changed dramatically. Now instead of becoming the next millionaire, I focus on not losing money. As long as I'm not in the negative at year's end, it's ok with me.

Conclusion About Options

My intentions in writing this article aren't to scare you away from trading options. I just want anybody that is considering investing in these equities to know what they're getting into. Options can be a great addition to your overall investing portfolio, but they should not make up your entire portfolio.

Invstopedia has a pretty good overview of options, and The Options Industry Council has some pretty good information on option strategies. I would recommend beginning with covered calls, and moving on from there. Learn as much as you can and paper trade before placing any of your real dollars into these risky investments.

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Comments

Jan 4, 2011 5:09pm
aguy
Selling covered calls is a much less risky way of using options, but there are risks there, too. All investments have risk. Nice first hand account of your experience.
Jan 4, 2011 5:33pm
Signor-Bluth
Yeah, you're right about the risks of covered calls. Thanks for the comment.
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