All investment carries some risk, and trading options is no different. In options trading, the movement of the option can differ greatly from the underlying security. This is the reason that trading options can generate spectacular returns.
While the underlying security may only fluctuate by 2%, a typical option for that security could fluctuate by around 25%. This can be an advantage in a rising market, but it can also translate into big losses if the market turn downward.
Although the risks of losing capital are greater, the risk is often worth the reward. This is due to the shifts in volatility, making the rewards and risks not necessarily the same as if you were invested in the underlying stock.
In options trading, the potential gains from rising prices are greater than the potential losses from falling prices. You can still experience a loss of capital if the stock price drops, but since options trading allows you to gain more than you could lose, many investors find that trading options is a more beneficial long-term strategy.
Trading Options And Leverage
When you are trading options, an important factor to consider is the use of leverage. Leverage enables you to control a larger position with a smaller initial investment. You can greatly reduce your exposure to risk, because you are putting up less capital initially in order to control a larger position.
With leverage, instead of risking $5,000 on a stock purchase, your options premium may be as low as $300. While this leverage reduces your initial investment amount, it also greatly increases your exposure. Your level of exposure is less only if you chose to control a set amount of stock using less capital with options.
Stocks Not As Risky As You May Think
While the stock market has a reputation for being a risky endeavor, the risk associated with securities is a bit overstated. While there is certainly the possibility of a total loss of investment capital, the chances of a company’s stock working its way down to $0 is slim.
Even in the worst cases (think WorldCom or Enron) it could take up to a whole year for the stock to devalue, as mutual funds and large stake holders have to stagger their sales over time, and it is logistically impossible for a company’s shares to liquidated overnight.
Depending on the stock, your actual risk is more along the lines of 50%. In actuality, your risk is rarely at 100% when you are investing in the stock market. So while your risk in the stock market may be low, due to an option’s expiration date, you are actually exposing yourself to a risk level of 100% when using options.
If you do not act before the option’s expiration date, you will lose your entire investment in that option. Even if you are a buy-and-hold investor, you can not simply let options sit still. You must track the worth of your investment every now and then.
If you are not able to do that, then investing in options may not be for you. These are time-sensitive investment instruments, and there are huge consequences for not treating them as such. With all of options potential rewards, you must pay attention to them in order to profit from this investment strategy.