Options
The Risks of Options Trading Most Beginners Miss
Options can be useful tools. They can also lose money faster, and more completely, than owning the stock. Most of the ways they do it aren't obvious until it happens to you.
1. You can lose everything you paid
When you own a stock and it falls 30%, you still have 70%. When you buy an option and the stock doesn't move far enough, fast enough, the option can expire worthless: a 100% loss. That happens often with out-of-the-money options, which are cheap precisely because they usually expire worthless.
2. Time decay works against buyers
Every option's time value shrinks as expiration approaches, and the shrinking speeds up in the final weeks. If you buy an option and the stock goes nowhere, you lose money every day. Being right about direction isn't enough; you also have to be right about timing.
3. Volatility can collapse after the news
Before big events such as earnings, option prices often rise because implied volatility rises: the market expects a big move. Once the news is out, implied volatility usually drops. Buyers can be right on direction and still lose money if the stock moves less than the option prices had assumed.
Example. Before earnings, a $100 stock's at-the-money call costs $6, pricing in a large move. The company beats, and the stock rises to $104. The next day the call is worth $5 because volatility collapsed: a 17% loss on a correct call.
4. Leverage cuts both ways
Because one contract controls 100 shares for a fraction of their cost, small stock moves create large percentage swings in option value. That's the appeal, and the danger. It is easy to end up with far more exposure than you'd ever take in shares.
5. Some selling strategies have very large risk
Option sellers collect premium but take on obligations. Selling calls on stock you don't own (naked calls) has theoretically unlimited risk, because a stock can rise without limit. Selling puts can obligate you to buy shares at the strike even after a collapse. Brokers restrict these strategies and may require margin, and a sharp move can bring a margin call.
6. Assignment and exercise surprises
American-style options can be exercised early, so sellers can be assigned before expiration. At expiration, in-the-money options are generally exercised automatically, which can leave you with a stock position, and the capital requirement that comes with it, on Monday morning.
7. Wide spreads and thin trading
Many options trade rarely. The gap between the bid and the ask can be a large percentage of the price, so you lose money the moment you trade. Use limit orders, and check volume and open interest first.
How to protect yourself
- Read Characteristics and Risks of Standardized Options, which your broker must provide before you trade.
- Only risk money you can afford to lose completely.
- Know your maximum loss before you enter any trade.
- Avoid strategies with undefined risk until you fully understand them.
- Model the trade at several prices and dates.
See profit and loss at expiration for a long call, long put or covered call.
Common questions
Why did my call lose value when the stock went up?
Often because of time decay or a drop in implied volatility. If the stock rises less than the market expected, or rises slowly, the option's time value can shrink faster than its intrinsic value grows.
What is an IV crush?
A sharp drop in implied volatility, often right after an earnings announcement. Option prices fall because the uncertainty they were pricing has passed, even if the stock moved.
Are options riskier than stocks?
Buying options concentrates risk: you can lose 100% of the premium in a short time. Some selling strategies carry losses far larger than the premium collected. Options are not suitable for every investor.