 | About MeMy name is William Lewis and I enjoy hiking, eating and spending time with my friends. InterestsI love to travel and try new food in my home town of New York. If you know of any new restaurants in the East Village, send me a line and tell me about it. My current passion (and way to support my travels) is the options market. I posted an article below with my thoughts on the risks. |
The Risks of Trading Options
Trading options can be a very risky business when you are writing the options. With all equities, there are buyers and sellers for that is what a stock exchange is. The difference between buying and selling equities (stocks) and options is that in the former, the seller is required to already hold a position with the stock. That means they have already invested their own capital in the equity and they can either profit from the rise of the stock or its drop if they take a short position on it. But, even if they take that short position on it, they still have the asset value of the original position as collateral. Much like buying a second home, your first home is the collateral for the bank to risk loaning you the second mortgage investment.
This is not necessarily the case when trading options. The way option writers make money is my offering to sell the rights to an option they do NOT own. By not owning the option, they have not invested their hard earned capital in that equity so they make money by selling that option and then setting the strike price either high enough (for a call option) or low enough (for a put option) that the stock price never reaches that strike price. If that happens, the stock price never reaches the strike price in the time allotted by the contract, the buyer of either the put or the call will not exercise their right to buy and the seller earns the premium the buyer paid for the chance to profit.
What happens if the stock price DOES reach the strike price? If any of these terms confuse you, please visit http://www.incomeforums.com to learn what it all these financial and trading terms mean. The buyer will exercise their right to buy the equity forcing the seller to purchase the equity in order to sell the right to them. The seller is hoping that doesn't happen because of that required purchase as they do not want to be forced to invest that capital. Now, what happens if the stock prices keeps rising on a call option? The seller could easily lose a lot of money having to buy the equity at the market price.
The same would apply to a put option if the stock price did reach the strike price and kept going down. The only difference between these two disasters for the seller is that the put option has a floor--a lowest point the stock price cannot go below (0) so there is an automatic hedge for a put. There is no such hedge for a call.
The only way a seller can avoid these risks is by using covered options. Covered options are those where the seller essentially buys insurance against the above two scenarios by actually purchasing the stock before choosing to trade the options (see this page for more: http://www.incomemaster.com/options-trading/) to that stock. This way, they have the collateral (the market value of the stock) to pay the buyer of the call option or put option and are safe from financial disaster.
Option buyers have little risk other than losing their premiums when the stock price does not reach the strike price set by the option seller within the time frame also set by the seller. However, those premiums can get high so options buyers need to be careful as well.
Examples of the above:
Call Option: An equity has a market price of $50/share. The seller of the call option sets the strike price at $60/share and a time limit of 30 days. A buyer purchases 100 shares of the option on the hope the stock value will rise to $65 by day 29. If it doesn't, the buyer is out $50 as the call is not exercised because the stock price never reached the strike price within the time limit. The seller collects $50 for doing nothing other than offering the deal. Good work if you can get it.
However, if the stock price reaches the strike price, the buyer exercises his right to buy at $65/share. The seller must sell the option but to do that, he first has to buy the underlying stock for %65/share x 100 shares or $6500 to do that. The buyer would simply earn the difference between that $6500 and the original $50/share x100 shares or $5000. If the stock price keeps rising to 70 or 100, the seller can lose a lot of money very quickly while the buyer dances in the streets. The same can happen on a put option with the caveat as mentioned above that the most the seller can lose is the total value of the stock (when its price reaches 0).
Trading options can be a very risky business when you are writing the options. With all equities, there are buyers and sellers for that is what a stock exchange is. The difference between buying and selling equities (stocks) and options is that in the former, the seller is required to already hold a position with the stock. That means they have already invested their own capital in the equity and they can either profit from the rise of the stock or its drop if they take a short position on it. But, even if they take that short position on it, they still have the asset value of the original position as collateral. Much like buying a second home, your first home is the collateral for the bank to risk loaning you the second mortgage investment.
This is not necessarily the case when trading options. The way option writers make money is my offering to sell the rights to an option they do NOT own. By not owning the option, they have not invested their hard earned capital in that equity so they make money by selling that option and then setting the strike price either high enough (for a call option) or low enough (for a put option) that the stock price never reaches that strike price. If that happens, the stock price never reaches the strike price in the time allotted by the contract, the buyer of either the put or the call will not exercise their right to buy and the seller earns the premium the buyer paid for the chance to profit.
What happens if the stock price DOES reach the strike price? If any of these terms confuse you, please visit http://www.incomeforums.com to learn what it all these financial and trading terms mean. The buyer will exercise their right to buy the equity forcing the seller to purchase the equity in order to sell the right to them. The seller is hoping that doesn't happen because of that required purchase as they do not want to be forced to invest that capital. Now, what happens if the stock prices keeps rising on a call option? The seller could easily lose a lot of money having to buy the equity at the market price.
The same would apply to a put option if the stock price did reach the strike price and kept going down. The only difference between these two disasters for the seller is that the put option has a floor--a lowest point the stock price cannot go below (0) so there is an automatic hedge for a put. There is no such hedge for a call.
The only way a seller can avoid these risks is by using covered options. Covered options are those where the seller essentially buys insurance against the above two scenarios by actually purchasing the stock before choosing to trade the options (see this page for more: http://www.incomemaster.com/options-trading/) to that stock. This way, they have the collateral (the market value of the stock) to pay the buyer of the call option or put option and are safe from financial disaster.
Option buyers have little risk other than losing their premiums when the stock price does not reach the strike price set by the option seller within the time frame also set by the seller. However, those premiums can get high so options buyers need to be careful as well.
Examples of the above:
Call Option: An equity has a market price of $50/share. The seller of the call option sets the strike price at $60/share and a time limit of 30 days. A buyer purchases 100 shares of the option on the hope the stock value will rise to $65 by day 29. If it doesn't, the buyer is out $50 as the call is not exercised because the stock price never reached the strike price within the time limit. The seller collects $50 for doing nothing other than offering the deal. Good work if you can get it.
However, if the stock price reaches the strike price, the buyer exercises his right to buy at $65/share. The seller must sell the option but to do that, he first has to buy the underlying stock for %65/share x 100 shares or $6500 to do that. The buyer would simply earn the difference between that $6500 and the original $50/share x100 shares or $5000. If the stock price keeps rising to 70 or 100, the seller can lose a lot of money very quickly while the buyer dances in the streets. The same can happen on a put option with the caveat as mentioned above that the most the seller can lose is the total value of the stock (when its price reaches 0).
