Options trading has become extremely popular since we got stuck with the pandemic in 2020, from there came the birth of the retail trader and also the connotation that options trading is inherently dangerous and risky. So why is options trading considered risky?
There are a lot of retail traders that actually became millionaires through options trading, remember the meme stock fiasco of 2021? Where did we see gamma squeezes and short squeezes by retail investors or so they thought? I’m stocked like GME GAMESTOP and AMC? Well if these “apes” can do it then what’s risky about it? The reality with options trading is you can lose it all really quickly if you do not understand the fundamentals of options trading, it’s that simple. Options can go to $0 very quickly, until stocks or some other assets options expire, meaning if the criteria are not met then the options are going to expire worthlessly. Making it inherently risky, if you are unsure of what you’re doing.
Understanding there are two main types of options is a start at understanding risk. The put and the call, are directional options. Whichever you select you will anticipate that the market will make a move in either direction. Up or down. The risk can be a smaller amount of the premium you paid, or technically unlimited. This is the complexity of the options world.
Let’s break down the components of options trading that make derivatives trading risky.
The Tops 3 Options Trading Risk
Options trading is considered risky because of the following reasons:
- Options are used to speculate shorter-term direction & poor risk management (usually)
- Options are highly leveraged derivative instruments (complex and volatile)
- Options have expirations
In this section, we will break down the reasons why traders usually experience losses and deem options trading risky. In the following, we will break down solutions for all these issues.
1. Options Are Used to Speculate Shorter-term Direction (Usually)
Options are divisible into two main categories as mentioned before, calls and puts. There are both call buyers and sellers. Along with put buyers and sellers. The buyers give the premium to hold the contract to the sellers. Meaning the maximum the seller can gain is the premium on the options when they expire worthlessly. The max loss however is technically infinite for call sellers because they want prices to stay under a certain area. While a stock’s price can theoretically rise to infinity. While the put sell max loss is the difference between the stock’s price and 0. A stock can only go down to 0. The buyer’s gains are theoretically the inverse of the seller’s losses. You can learn all about options at TRADEPRO Academy.
Options are seen as risky because traders often “guess” the direction of the market and choose to buy calls or puts accordingly. Which isn’t really the best of moves. Usually, traders use these options as short-term estimates or short-term options which results in a quicker loss of capital. Rather than understanding what causes market movements and using longer-term direction, there is a lot of potential reward in short-term options that increase and decrease in price quickly. This leads us to our next point shortly.
Overall a trader can anticipate the direction of the market move on a single day or week and trade options accordingly, now retail traders are usually wrong in which direction the market will move. Because of emotion, lack of understanding, and some potential external factors. This causes larger losses of capital and a lot of that is actually due to poor management. Instead of cutting losers quickly, traders often let the position just run into the ground. Losing the whole premium or the majority of the premium. That is not trade, at that point, it is a gamble. Will the stock go up or down, and risk $X for that move. This then goes in your favor and traders experience greed, not taking profits, turning the position into a loss.
2. Options Are Highly Leveraged Derivative Instruments (Complex and Volatile)
Options are considered highly risky because they are leveraged instruments, meaning they’re high-risk high reward instruments. With higher leverage, you get a product that acts as if it were to have a massive notional value. So the leverage would make minor movements in the underlying really exaggerated in your position. For example, a premium of $1,000 can get obliterated based on a $1 move in the underlying. Naturally depends on multiple other factors. As a derivative instrument, options pricing and movement are derived on an underlying basis. Just like stock and or ETFs. AAPL (Apple Inc) and the SPY (S&P500 ETF) have options. However, when AAPL stock moves $1, you gain $1 times the shares you have. When you have an AAPL call and the underlying gains $1, the underlying might gain $40 per contract.
This is why options are complex, here are the main complexities that affect options pricing and volatility:
- Expiration: Options have a finite life and the shorter expiries are more volatile.
- Moniness: Options have different strikes, some really far from price in either direction. The farther away from the underlying price, above for calls and below for puts is considered a “target” and OTM or out of money. These are going to be cheaper and much more attractive to traders. Cheaper, with a potential to make much more return on investment? Sign up the retail traders! While this is the opposite of what happens, they’re priced like this because the probability of success is so low. Once every 1000 these might hit.
- The options Greeks: Delta, gamma, theta, vega. All of these contribute to options pricing and how the options price moves based on the underlying. These contribute to the potential gains, losses, and more in options selection. You can read more about from HERE. Options are mainly seen as risky because traders do not take the time to understand options greeks and how they work. This is step one of understanding your risk.
- The options volatility measure: This is a portion of vega (Greek), usually denoted by implied volatility. Which has an effect on the options price. No matter if volatility goes up or down the price of a stock will still be worth $1 less or $1 more based on the shares you hold. $1 move in stocks will never equal a $2 change. In options, however, when implied volatility increases the bought options gain value, and the sold options lose value. This is due to uncertainty in the market. Volatility measures can really help or completely destroy positions and reading volatility and these uncertainties is why traders consider options trading risky.
3. Options Have Expirations, Selection Matters
As we mentioned above, options selection is a huge part of options trading and people generally don’t know which options to select. Which you can read a lot about in this article.
Options trading is deemed risky because there are multiple choices, multiple expirations dates that traders can select from and oftentimes traders don’t select the right expiration for the right purpose. To break it down simply, there are 3 categories of options trading, and options selection fall under one of these.
- Day trading: Options expire within 2-weeks at the most.
- Swing Trading: Options can expire between 2weeks and months.
- LEAP Trading: Options typically expire in 10 months, minimum.
The short-term options are generally the most attractive because they are the cheapest. The farther OTM the option, and the closer it expires the cheaper it is, which is what a lot of traders, as newer traders look for so they can buy many and ideally strike gold. However soon you will realize that this is not the way and these positions will evaporate. Another mistake made is that traders are so deep in a loss on the day trade position they have going on that they just hold onto it and turn a day trade into a swing trade, holding it overnight on a really short expiry. This is the hopium of a trade, where you hope you can get back to break even. Rather than having a system in place, making trading seem riskier.
How to Avoid Options Risk?
In this section, we are going to come up with solutions for the above-mentioned 3 pillars that make it SEEM that options trading is risky, and why traders often lose money trading in specific ways. This is not a way to completely avoid risk. We can cut risk down and manage it, however each trade we take, we have to understand that there is going to be an inherent risk associated with it.
1. Options Are Used to Speculate Shorter Term Direction & Poor Risk Management (Usually)
Options speculation for the shorter term can be done right and with a risk management perspective in mind. Overall we don’t have to “guess” where the options are going, we can understand the overall flow of the market with:
Understanding these concepts will help you identify better trades in the market and understand what is going on from an institutional level in trading. Which can help you manage risk, you don’t want to go zero or hero if you do not plan on it from the beginning in trading options. You can take a look at this article for more on that.
If you understand where the general trend is on the market or specific sectors you will have an easier time trading, and not just guessing random directions. This is the key to limiting the “risk” in options trading.
2. Options Are Highly Leveraged Derivative Instruments (Complex and Volatile)
There is an easier fix to this, traders can learn the theory and functions of the largest components that affect options pricing, which is typically the Greeks. If you understand how the Greeks move and how they affect the price you can break down how you should go about trading options. For example:
If you are a day trader, you don’t want to be selecting options that are not liquid. This means if the open interest and the volume are low, you do not want to look to trade those options. Ideally, options contracts that have 500-1000 of each are REALLY liquid. The spread between the bid and ask is going to be tighter as well.
This also has to do with the Delta of the options. If you go too far out of the money, then the delta is going to be really low, and it will make a big move for those options to gain profit, even though they’re cheaper, they are not better. So as a day trader always consider 25-35 delta as a staple when selecting options.
One of the final pieces of the puzzle is understanding volatility. Now you don’t have to be a volatility expert or a quant, but you should understand the basics of volatility and when to play options but also when to avoid them. Volatility is a measure of uncertainty in the markets and when we see increased volatility options prices are going to get more expensive and the spreads wider. Shorter-term options are going to be really risky. Just like Fed events, so you can go a week farther out or even learn how to sell options in a high IV environment.
3. Options Have Expirations & Selection
Options expirations and selection are really important to understand, a lot about that is posted in the article above. The main thing you need to realize is that options that expire weekly or intraweekly are mainly meant for quicker scalps and even to be sold for a premium. You should always buy more time in the options expiration than you think you need to save yourself the potential of options Greeks killing your positions.
Make sure you understand the concept of time decay in making these decisions. At the same time, the selection is dependent on the Greeks and a lot of what we talked about above.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO AcademyTM is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.