Written by A.J. Brown

Are Options Risky… Really?

Options RiskyAll trading involves risk, no matter if you’re trading stocks, options, FOREX, or futures. Some people argue that options are riskier than other types of financial instruments. Is this really true?

I think, in general, options will always be riskier than other types of investments. Why? Because the premium you pay for an options contract can drop to zero. In fact, the CBOE reports that 30% of options contracts expire worthless.

Obviously, if you own a stock outright, the possibility of its value falling to zero is quite slim. Only in cases where the company goes bankrupt do you stand to lose your entire investment. But with options, it is not uncommon to lose the entire amount of your premium.

Let’s look at a hypothetical example. Let’s say you want to buy a call option on XYZ stock. And let’s assume the premium for this option is $2.45 and the strike price is $40. Currently, the price of the stock is at $36. So you pay a total of $245 ($2.45 x 100) for a call option on this stock, not counting commissions or fees.

From the moment you buy the option, time erosion kicks in. The value of your option begins to deteriorate as the expiration date draws nearer. If the price of the stock begins to rise, then the value of your option will go up, despite the effects of time erosion. If the price of the stock rises to $39 (one dollar below the strike price), you may be able to sell your option at a profit, even though the option isn’t in-the-money yet.

On the other hand, if the price of the stock stays flat… or worse… drops–then it is not likely you will make money on your option. Best case, you sell the option for a loss and recover a portion of the premium you paid. Worst case, the option expires worthless and you lose your entire investment.

This, in a nutshell, is why trading options is considered risky. So if this is the case, why do people do it?

The answer is simple. People trade options because it gives them leverage.

In our imaginary example, we invested $245 for one call option. This same money, if invested in stocks, might have purchased 10 shares at $24.50 each. And if the price of the stock had risen by $2, we would have profited $20 ($2 x 10 shares = $20). On a $245 investment, this is a modest 8.16% gain.

Buying the option on this same stock provides more leverage. If we had invested $245 and the price of the stock had risen by $2, then the value of our call option may have risen to $400, a not unreasonable figure. By reselling our option back into the market, we would profit $155, or 63.3%.

Which would you rather have: a profit of 8.16% or one of 63.3%? Are you beginning to understand why many people choose to trade options?

Once you’ve made some winning trades, you can then "snowball" your profits into more or larger options contracts. Obviously, the risk never goes away, but neither does the leverage. And the risk of options trading can be reduced if you follow some simple trading rules. I discuss some of these rules in my Trading Trainer membership site. If you are interested, you can learn about it here.

Best Regards Always,

A.J. Brown

Categories: Education / Options

5 Responses to “Are Options Risky… Really?”

  1. Who Trades Options? @ 8:59 am (Pingback)

    [...] In case you missed it, you may also be interested in this article: Are Options Risky… Really? Tags: making money, traders, trading [...]

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  2. Rachel @ 3:53 pm:

    I’m getting into Options …..

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  3. Grady Gantner @ 8:07 am:

    Howdy I really admired your blog post. Don’t stop the awesome work!

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  4. Fausto Rone @ 8:59 pm:

    Detailed post can i translate into Russian for our sites viewers? Thanks

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  5. Pierce @ 1:07 pm:

    Just like to say very good article, informative and great examples

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