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Options Trading ? Another Look at Risk

By  Jan 20, 2011

Topics: Finance & Investing

Options traders need to constantly revisit the issue of risk. No one can escape the various kinds of market risk, and options are exceptionally associated with this reality. Even though many strategies are very conservative, every trader needs to know the risk levels involved in a strategy -- before they commit cash.

1. What if buyers outnumber sellers? The options market is both efficient and liquid. For those high-volume stocks that also offer dozens of strikes and expirations, the Options Clearing Corporation (OCC) facilitates the market. It acts as buyer toe very seller, and as seller to every buyer. This means that even in a market leaning in one direction, traders will be able to place trades, whether buying or selling.

2. If I buy an option, do I have to buy or sell stock? Not at all; in fact, as the buyer you have several choices. You can sell to close a long position any time you want before expiration. So the position may become profitable or, if not, you can still close to cut your losses. If the position is in the money at expiration (meaning the stock price is higher than a call’s strike or lower than a put’s strike) you would want to close it out before it expires to avoid having it automatically exercised. But the great feature of long options is that your risk is never greater than the cost of the option.

 3. If I sell an option, will I be required to buy or sell stock? It’s a different story when you go short. If your short call is in the money at expiration, it will be exercised and you will be required to sell 100 shares at the strike, even though the current value of stock is higher. If your short put is in the money, you will have 100 shares put to you at the strike, which will be higher than the current market value of stock. This is most likely to occur on the last trading day, but short sellers should realize that exercise can happen at any time that an option is in the money.

4. Can I avoid exercise? Yes. There are several ways that you can avoid having a short option exercised. First, you can close the position with a “buy to close” order. This may be a profitable move as long as the net purchase is lower than the original sale. Second, you can cover the position by buying a long option that expires later or at a different strike (higher for calls or lower for puts). Finally you can roll forward -- close the current position and replace it with a different option that expires later.

5. Are option risks too high? The answer depends on each person’s risk tolerance and also on the specific strategy itself. Some are quite high-risk, like writing uncovered calls or setting up short straddles, for example. Some strategies are extremely conservative, however, such as writing covered calls or opening a collar (owning 100 shares, selling a covered call, and buying a put). Risk with options covers the entire range from speculative down to ultra-conservative, so traders need to analyze the attributes of a position before putting money at risk.

A smart move before committing your cash is to paper trade. You set up a “virtual portfolio” and then make trades, enabling you to see how values change in a real environment -- but without putting any cash on the line. The CBOE (www.cboe.com) offers a free and excellent virtual trading link on their website. On the home page, link to “trading tools” and then to “Virtual trade.”

Michael C. Thomsett is an investing and options author and has also written for FT Press’ Agile Investor series, which can be viewed on FTPress.com. Thomsett’s latest FT Press book is Trading with Candlesticks.