Options Trading Risks

| November 22, 2011 | 0 Comments

Option holders and writers are exposed to specific risks that are unique to options. These risks are set forth in the official disclosure document published by The Options Clearing Corporation, “Characteristics And Risks Of Standardized Options“.

Before your broker will allow you to buy or sell an option listed on the U.S. options market, you must first read a copy of this disclosure document.

In order to have success trading any market, it is important to have a firm understanding of the various risks of trading in that market. The options market is no exception. The unique risks taken by option holders and writers are discussed in Chapter X “Principal Risks of Options Positions”. Protect yourself by completely understanding the risks of your chosen option trading strategy before committing your hard earned capital to it.

The following discussion of option trading risks is intended to be a summary of the risks presented in Chapter X and is not meant to be a substitute for the actual disclosure document.

Option Trading Risks Unique To Option Holders

  1. Option holders risk losing the entire amount paid for an option in a relatively short period of time.Failure to sell an option in the secondary market or exercise it prior to expiration may result in a complete loss of the entire investment in the option. This means that you must be right regarding the direction the underlying security’s price will move as well as the timeframe in which the expected move will happen. The amount of leverage utilized with the option will significantly affect the amount of any potential loss.
  2. The risk of losing all or part of the amount paid for an option increases as the option moves further out-of-the-money and approaches its expiration date.
  3. The holder of a European-style option assumes the risk that a secondary market for the option will not be available before it becomes exercisable, and that he will not be able to sell the option during that time period.
  4. The exercise provisions of an option contract may create certain risks for the option holder.(a) A holder of an option without an automatic exercise feature assusmes the risk that it will not be exercised if he fails to exercise it prior to expiration.(b) An option with an automatic exercise feature presents different risks for the option holder:(1) The option may be exercised at a price the option holder would not choose to exercise it. For example, the exercise of an option having a cash settlement amount less than the transaction costs of exercise would result in a net loss for the option holder.(2) An option that could be exercised profitably may not be exercised if the cash settlement amount is less than the minimum amount required for automatic exercise.
  5. The courts, the SEC, another regulatory agency, OCC, or the options markets may restrict exercise of an option and cause the option holder to remain locked into the position until the restriction is lifted.

Option Trading Risks Unique To Option Writers

  1. An option writer may be assigned an exercise at any time during the period the option is exercisable. Notice of the assignment may not be provided to the option writer until after the assignment has been made by OCC. Once an exercise has been assigned, the option writer may not close out the position.(a) American Style Option – an exercise may be assigned to the option writer from the time the option is written until the option expires or until the writer has closed out the position in a closing transaction.(b) European Style Option – an exercise may be assigned to the option writer only during the period that the option is exercisable.
  2. The writer of a covered call option risks missing potential profits from an increase in the underlying security’s value above the option’s exercise price but continues to bear the risk of loss in the value of the underlying security.If a covered call is exercised, the option writer might receive net proceeds from the sale of the underlying security that are substantially less than its market price. If the value of the underlying security declines and the call option is not exercised, the option writer could have an unrealized loss on the underlying security (the loss, however, would be partially offset by the premium received when the option was written).
  3. The writer of an uncovered (naked) call option risks potentially unlimited losses if the price of the underlying security rise above the exercise price.If an exercise is assigned, the option writer must buy the underlying security in the market and deliver it to the option holder. The writer will take a loss if the cost of buying the underlying security is greater than the amounts received from the exercise and initial sale of the option. The loss is potentially unlimited because there is no limit on how high the price of the underlying security can increase.
  4. The writer of an uncovered (naked) put option risks substantial losses should the price of the underlying security fall below the exercise price.(a) Physical Delivery Put Option – If an exercise is assigned, the naked put writer must buy the underlying security from the option holder at the exercise price, which could be substantially higher than the market price. An additional risk is that the put writer may become subject to a margin call when purchasing the underlying security.(b) Cash Settlement Put Option – If an exercise is assigned, the naked put writer must pay a cash settlement amount that reflects the decline in the value of the underlying security below the exercise price. If the put is not a cash-secured put, the put writer is required to maintain margin with the brokerage firm.(1) Cash Secured Put – the put option writer can avoid exposure to margin requirements by depositing cash in the account equal to the option exercise price. If an exercise is assigned, the put writer will have cash in the account to cover the purchase of the underlying stock. The cash secured put option writer is still subject to a risk of loss if the value of the underlying security declines in value.
  5. The put option writer may reduce the risk of loss by hedging the position through the purchase of other options on the same underlying security or by acquiring other securities in other markets.
  6. The writer of an uncovered call or put option, that is not cash secured, who is later unable to meet the broker’s requests for additional margin payments risks having the brokerage firm liquidate the options and other securities positions with little or no notice.
  7. Due to the leverage provided by an option, the writer of an uncovered and unhedged option may have significantly more risk than a short-seller of the underlying security.
  8. An uncovered option writer of physical delivery call stock options that are exercisable faces unique risks when the underlying security is the subject of a tender offer, exchange offer, or similar event.A writer who fails to purchase the underlying security on or before the expiration date of an offer may find out afterwards that he has been assigned an exercise. At that point, the writer may be unable to purchase the underlying security or exercise another option in order to deliver the security on the settlement date for the option exercise. Failure to make timely settlement can result in the writer becoming liable for the value of the offer. This risk can only be avoided by purchasing the underlying security on or before the expiration date of the offer.
  9. There is a risk that an option writer will be assigned an exercise after the established exercise cut-off time. This exercise may be prompted by news that is published after the exercise cut-off time established by the options markets. The OCC is required to accept all exercises it receives prior to expiration even if they are filed after the cut-off time. The writer may not have an effective remedy to compensate him for the violation of these rules.
  10. If an option writer is unable to close out a position for any reason (even if the option market is unavailable), he is still obligated under the contract until expiration or assignment.
  11. If a sudden development causes a sharp spike in the value of the underlying security of a capped option, the spike could cause the option to be automatically exercised. The option writer would be required to pay the cash settlement amount even if the price spike is corrected on the day after the automatic exercise was triggered.

Other Option Trading Risks

  1. Advanced option strategies like spreads and straddles that involve buying and writing multiple options in combination with buying or selling short the underlying security present unique risks. An option trader who uses these types of strategies without understanding the risks created by their complexity may incur potentially substantial losses as a result.
  2. There is a risk that the trading market for a particular option may become unavailable and prevent the option trader from closing out a position. There is a further risk that there may be times when option prices will not maintain their relationship to the prices of their underlying securities.
  3. If the option markets halt trading of an option, the option trader will be unable to close out the position until the option resumes trading. While the option is halted, the option trader may sustain significant losses if the
    underlying security moves against the option position while trading is halted.
  4. All cash-settled options have unique risks. The risks unique to cash-settled index options are discussed in the section entitled “Special Risks of Index Options”. Risks unique to cash-settled options with a settlement currency other than the U.S. dollar are subject to the same risks discussed in the section entitled “Special Risks of Foreign Currency Options”.
  5. Holders and writers of capped options risk having their options automatically exercised based on an erroneous automatic exercise value reported by the official reporting source. If the options market fails to correct the error in timely fashion the option holder and writer will bear the consequences of the automatic exercise.
  6. If the option holder’s/writer’s brokerage firm or the OCC Clearing Member that carries the broker’s accounts becomes insolvent, their option positions could be closed out without the holder’s or writer’s consent.
  7. Due to differences in market hours and holiday observances between the U.S. and various foreign countries, the premiums of internationally traded options may not reflect current prices of the underlying security in the U.S.
  8. There is a risk that OCC and its backup system may fail which would cause delays in settling options transactions.

Conclusion

As you can see, options have unique risks that result from their structure, OCC rules and regulations, the structure and unique rules of the options markets, specific option strategies, and the type of security underlying the option. Before undertaking any option strategy, the experienced option trader considers the unique risks of the particular strategy and then develops a plan for reducing these risks or avoiding them altogether. Many of these risks can be reduced or avoided through the use of hedging strategies. The ultimate success of the chosen option strategy, the risk reduction plan, and hedging strategy will depend of course on proper and timely execution.

Category: Options Trading Basics

About the Author ()

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.

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