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Options are traded when investors expect the price of a stock to rise or fall within a certain period of time and they want to capitalize on the price change. With options, you have the right to buy or sell an asset at a certain price within a certain time frame (before the expiration).
But are options dangerous to trade?
Options are risky compared to other investments as you can easily lose your entire investment if the stock doesn’t go up or down before the expiration date (in the case of buying calls or puts).
How dangerous options are depends on whether you’re buying or selling options, if you’re trading call or put options, and if you’re trading specialized options like covered calls or protective puts.
If you sell naked calls or puts that can be far more risky than just buying calls or puts as you could be put far more than just the premium of the option.
In the rest of this article I will try to explain why call and put options are risky and the types of options that can decrease your risk. There are also some resources you can use to learn more about options trading and how it works.
To see the best books about option trading strategies just click here.
When Are Call Options Risky?
Call options are risky, and the risk is different for the buyer and the seller.
If you’re the call seller, also known as the call writer, you face risk because you’ll have to sell your asset, usually a stock, if the buyer exercises the option. If the stock price decreases or stays the same, you’ll keep the stock, and the premium is your profit on the sale.
However, if the stock price increases to or above the call’s strike price, there’s a risk. When this happens, the buyer will almost always exercise the call, meaning that you’ll have to sell them the stocks at the strike price.
If the current stock price is above the sum of the strike price and the premium earned on the sale, you, as the call seller, are lost out on some profit. You would’ve been better off not selling the call and just holding and selling the stock.
The situations are essentially reversed for the call buyer.
If you’re the call buyer, you need the stock price to reach the strike price or rise above it to make money on your call option investment. If this happens, you’ll exercise the call option and purchase the stock at the strike price (or sell the call at a profit).
Then you can hold the stock or sell it. The profit is the difference between the stock’s selling price and the strike price, minus the premium you paid for the call option.
The benefit of buying calls is that they are risky but that risk is defined. If the stock price doesn’t increase to your strike price, all you lose is the premium you paid for the option.
When Are Put Options Risky?
Put options have a similar risk to call options in that there’s a risk to both the buyer and the seller, and the one who loses money and the one who profits depends on how the stock price changes.
If you’re the put seller or writer, you want the stock price to stay the same or increase, unlike writing calls. If the price decreases to (or below) the option’s strike price, you’ll have to buy the stock at the strike price (have it put to you).
The strike price could be higher than the stock’s current price, so you’ll lose money on the difference.
Selling put options is risky because, while you may earn the option’s premium, your potential loss can be as high as the stock’s entire value.
Say you sell a put for stock XYZ with a strike price of fifty dollars and a current trading price of sixty dollars. If something happens and the stock price drastically decreases to ten dollars, the put buyer will exercise the option.
Then you’ll have to buy the stock at the strike price of fifty dollars. Your loss is forty dollars per share or four thousand dollars per option contract that you sold.
As for buying puts, you expect and want the stock price to drop under the strike price so you can sell your shares for more than what they are worth. If the stock price decreases and you exercise the option, your earnings are equal to the difference between the current price you would have sold without the put option and the strike price you sold at.
Buying puts is less risky than selling them because your maximum loss is limited to the premium you paid for the option, not the entire value of your stock.
How To Make Options Less Risky
There are types of call and put options you can sell that are less risky than the standard options mentioned above.
First, there are covered calls. With covered calls, you already own the stock or other securities that you’re selling calls for. You can sell covered calls as a way to make money on stocks that you already own and are planning to hold for an extended period.
If you’re selling covered calls and the buyer exercises the option, you already have all the stock you need to sell. But, your loss is the value of the stock that you own if it plummets while you hold it.
Covered calls are still less risky than standard calls because your loss is limited to what you spent on the stock.
Protective puts are similar, as the seller already holds the security that they’re selling puts against, so there’s less risk to the seller of the put.
Learn More About Options
Here are some books you can read to learn more about options trading so you can make smart trades and lower your risk.
Options Trading: The 2021 Crash Course (available on Amazon.com) will teach you the basics of trading options and how to get started with an options broker. You’ll also learn how to have a successful trading strategy in place to become a good options trader.
Option Strategy Hedging & Risk Management (available on Amazon.com) will help you manage your risk as you trade options. The author offers several strategies for you to try and other tools to help you trade better.
Options can be risky, and your potential loss depends on if you’re the buyer or the seller and if the options are call options or put options. If you have a few unsuccessful options in a short period, you can lose a significant amount of money fast.
If you want to trade options with less risk, you need to learn about how they trade and what strategies you can implement in your options investments.