Lesson 5: What are some of the main risks of buying options?
While there are advantages to trading options, there are also some important risks that you’ll want to understand up front.
CIBC Investor's Edge
5-minute read
While there are advantages to trading options, there are also some important risks that you’ll want to understand up front. We’ve referred to some of these risks already. While it’s not possible to address the circumstances of every potential options trade, this section is meant to summarize some of the main risks involved in options buying.
Investor’s Edge will provide a Derivatives Risk Disclosure Statement when you apply and are approved to trade options. Lesson 15 has more details and we recommend that you read it carefully before you place your first trade.
This lesson won’t explore the risks involved when you initiate an option trade as the option seller. This is a more advanced trade that we’ll discuss in later lessons.
In lesson 4, we explored how options can be used as a kind of insurance policy against unfavourable moves in your stock holdings. An important thing to remember if you’re using options this way is that options have an expiry date. For that reason, your protection has a limited lifespan, and you’ll need to purchase a new option to maintain it after each expiry date. This can mean you’ll continue to use capital to buy insurance against a move that may never happen.
If you’re buying a call or put to speculate on a stock’s movement rather than as an insurance policy, the same principles apply. Many options expire worthless because the underlying stock has not moved the predicted amount by expiry. If the option is out-of-the-money at expiry, and you’re still holding it, you’d lose all the money spent to originally purchase it. There may be opportunities to sell the option at a profit before expiry, but you’ll need to decide to take action to capture those gains. If the option closes in-the-money at expiry, you’ll need to either sell the option before the market closes on its last trading day or exercise it to create a long or short stock position.
Here's a summary of what can happen during the lifespan of a call or put option from the option buyer’s point of view:
Buy a call
Potential outcomes
- Sell before expiry for a potential profit or loss.
- Hold until expiry and the option closes in-the-money:
- Sell before market closes on its expiry day for a potential profit or loss.
- Exercise the call to buy the stock. You must have sufficient margin or cash available to make the stock purchase.
- Hold until expiry and the option closes out-of-the-money. The option expires worthless which means a loss of the initial purchase price (i.e., option premium plus commission).
- For American-style options, you can exercise before expiry. Again, you must have sufficient cash or margin available to make the stock purchase. In this situation, you’ll lose the remaining time value of the option, so it’s important to do the calculation to ensure that this action makes sense. If you want to close your option position, you should evaluate this strategy versus selling the option before expiry.
Buy a put
Potential outcomes
- Sell before expiry for a potential profit or loss.
- Hold until expiry and the option closes in-the-money:
- Sell before market closes on its expiry day for a potential profit or loss.
- Exercise the put to sell an existing stock holding or, in margin accounts, exercise the put to receive a short stock position. You must have sufficient margin available to undertake the short sale.
Note for registered accounts: since you can’t hold a short position in a registered account, in order to exercise the put, you must already hold the stock, then exercise the put to sell it. If you don’t hold the stock, you’ll have to sell the put before expiry to capture its value. If you take no action, the put will expire, the opportunity will be lost and you’ll lose the initial purchase premium, plus commission.
- Hold until expiry and the option closes out-of-the-money. The option expires worthless which means a loss of the initial purchase price (i.e., option premium plus commission).
- For American-style options, you can exercise before expiry. Again, you must either hold the underlying stock or have sufficient cash or margin available to sell the stock short in a margin account. In this situation, you’ll lose the remaining time value of the option, so it’s important to do the calculations to ensure that this action makes sense. If you want to close your option position, you should evaluate this strategy versus selling the option before expiry.
As your option position nears expiry, you can of course purchase a new option with an expiry date that’s further in the future. Obviously, this will require a new commitment of money. This can continue for many cycles as you wait for the stock movement you’ve predicted. Getting around this issue by initially choosing a longer expiration date is not a perfect solution because a longer-dated option will be more expensive than the equivalent closer-expiry option. In addition, the desired expiry date may not always be available.
While we’re discussing options expiry, remember that not only does the time value portion of an option’s price erode, it erodes faster as expiry approaches. Options that are close to their expiry date can lose value very quickly, even if the linked stock is moving in a direction that benefits you.
The option premium already factors in existing or predicted stock volatility
Option traders often look for opportunities to benefit from large stock price moves. For that reason, a popular choice could be options on stocks that already show large price fluctuations, also known as higher volatility, or are about to experience an event that could spark volatility, for example, before an earnings announcement.
What makes a profitable trade difficult in these situations is the fact that option premiums will increase as a stock becomes more volatile or has the potential to become volatile. Since the option’s price is already factoring in some future volatility, the stock will have to make an even larger-than-predicted move for the option price to rise substantially. In some situations, an option’s price will decline when a large move occurs, because an even larger move had been anticipated by option traders.
Option trades can play out quickly
While this will depend both on the underlying stock and the current market environment, profits or losses can sometimes be realized in a very short period of time. Some option strategies show large percentage gains or losses within minutes of entering the trade. Some option traders may consider this a risk, for other traders, a benefit. In either case, you may need to stay close to your Investor’s Edge option or stock quote screen to minimize your risk of losses or ensure that you exit your trade with your profit intact.
