Many investors consider options investing to be risky. There are several reasons why people think that, but let’s explore three actual risks associated with options investing.
The first risk has to do with expectations management. Novice options investors expect stock prices to move quickly.
While that can happen, it often doesn’t. These investors load up on short-term options contracts. When the stock doesn’t move in the direction they had hoped the contracts expire worthless.
Also, a stock can move in the right direction but the magnitude of the move is not enough. This scenario could be worse than had the stock moved in the wrong direction.
When the stock is not going in the direction you hoped you may decide to close out the options contracts and cut your losses. However, when a stock starts to inch in the right direction, you may be tempted to hold onto the contracts until expiration.
That may even be the correct action to take. But novices will not know the difference. Only through experience will these investors learn when to cut their losses. Even experienced investors won’t always get it right, but they will more often than not.
The second risk is buying out-of-the-money options simply because they seem cheap. Novice investors may load up on these “cheap” options hoping for a big payout.
Most people who attempt this strategy fail. Options are a wasting asset, and the expiration factor has caused many investors to lose money.
To counteract this problem investors should give the stock more time to move. If an investor is buying options contracts that expire in a month or less, the underlying stocks are unlikely to move enough to make this strategy profitable.
By choosing expiration dates further out you increase the chances of stocks making significant moves. While options contracts with longer expiration dates are more expensive than shorter-term options the increased expense makes it less tempting to load up on too many contracts.
The third risk concerns sellers of options contracts. Often sellers don’t appreciate that an adverse move can be quite costly.
This situation is more significant for call sellers than put sellers. When selling puts, options prices are capped as stocks cannot go below zero.
Losses with call selling, though, can be unlimited. In the late 1990s, it was not unheard of for the prices of stocks to increase by forty to fifty dollars or more per day.
These were abnormal times, but you never know when such events can occur, leading to significant financial pain for sellers of options contracts.
How to limit your risk
Learning about the risks associated with options is one of the best ways to limit the losses.
Options investors should engage in money management and risk mitigation. The parameters may be different around options than for trading stocks. Nevertheless, implementing trading rules is crucial for all investors, irrespective of the assets traded.
Investors can use options to lower risk when they understand these financial instruments. For instance, an investor can use puts as a form of insurance on a stock or an entire portfolio.
When investors buy a stock he or she also can purchase a put on the stock to limit any downside risk. Some investors purchase puts on the market itself, such as an index ETF. SPDR S&P 500 ETF Trust (SPY) is an example of an index ETF that tracks the S&P 500.
Investors also can buy calls with longer expiration dates as substitutes for buying the stock outright. The maximum risk associated with buying options is the premium.
In many cases, these premiums are quite low, which helps to reduce overall risk.
Novice options investors should start with small positions. The temptation to make big gains quickly will drain capital and leave them with the impression that options are too risky.
When investors limit the number of contracts and keep the costs low they often soon learn how markets work. They may even make some money in the process.
After gaining some experience you can choose to implement more aggressive strategies, if desired.