option risks

We’ve all been there.

As soon as you open your first option brokerage account you are hit with the big option risk book.

Yes, we are referring to “Characteristics and Risk of Standardized Options”. Every broker will send this out to new option accounts. The hope is that this booklet will act as a disclosure and shed a light on the real risks in option trading.

To this day, I’ve never met anyone that has read this book. Who would? It is a 200-page pamphlet filled with topics such as, Foreign Currency Options, Flexibly Structure Options, Tax Considerations, Transaction Costs, and Margin Requirements, etc.

Boring!

Before you can get serious about trading options, you need to understand the real risks in your trades. We are going to go beyond Flexibly Structure Options (what does that even mean?) and cover knowledge, the free lunch, emotion, liquidity, and time.

Beware Of A Lack Of Knowledge

In my interview with SmallCapPower (read the full interview here) I was asked, “So what are some of the risks associated with options trading that investors should be aware of?”

My answer, “The biggest risk with options trading is simply the lack of knowledge with options. A lot of people see the leverage that options offer, they see all the great things you can do with options, but they don’t really understand them.

They’re going out there and they’re buying things, which is fine when it comes to options because you have a limited risk. But then they’re also selling options because they see people like me who can create these strategies where you sell options and you have a high probability of success.

Problem is that works until it doesn’t when you don’t have that knowledge. If you’re selling options, let’s say, on the S&P 500 and you’re doing great, and you’re doing great because the market is generally running neither flat or up.

But then you get something like Brexit and the market starts coming down and you start to panic. You don’t know what to do. You just don’t have that knowledge. “How do I adjust? What’s the next step to take? Do I simply close it out? Do I do this? Do I do that?” That’s the biggest risk with options is that you just don’t have the knowledge that you should when you go in and start trading, and you put yourself in really bad positions because you’re really not prepared for the bad stuff.

You just don’t have a plan of attack, and that’s just because you don’t know what to do next, and then your emotions start to take over and things start to go really bad.”

No one likes to think they don’t know everything. This is especially true when it comes to options and trading in general. There seems to be a lot of “professionals” out there. In reality, there are a lot of moving parts in options trading. It makes it very difficult to know everything or even to know enough to be successful.

It is very easy to get into a trade that you shouldn’t be in. Sometimes it works out, sometimes it doesn’t hurt too much, but others can wipe out your portfolio.

We’ve seen a lot of traders try to open a bull call spread, but actually open a bear call spread. They think the risk is small, a debit, but in reality the risk can be very big.

Don’t stop learning.

Grab a book, read a blog, practice with paper money, but never stop learning.

There are a few topics you should understand before you place an actual trade. You should understand the different order types to make sure you are placing the trade you want to trade.

Know the profit and loss for the trade and how each one is achieved. You never want to enter a position without fully understand how and where you are going to make your profit. For now, it is best to understand how the price needs to move for you to be profitable or where your losses will come in. Trying to understand the Greeks at this point will be cumbersome, especially if you don’t have a lot of real world experience under your belt.

What is implied volatility and how does it affect your trades? There are books and whole websites dedicated to implied volatility and how to trade it. It is a very complicated subject. When you start trading options you need to understand the very basics of implied volatility.

You want to know how each position is affected by an increase or decrease in implied volatility. You also want to know how to read the current implied volatility and know if it is high or low compared to its history.

As you learn and increase your knowledge keep your positions sizes small and easy to manage. There is no need to “get crazy” and go all out while you are learning. Most option brokerages have very reasonable option commissions, this will allow you to make money while risking very little.

No Free Lunch

There are no free lunches in the market. TastyTrade defined it best, “There is no such thing as a risk free trade in the markets.” TastyTrade goes on to specifically talk about arbitrage and how these opportunities are not available until you run a high speed trade computer, but the “free lunch concept” doesn’t stop at arbitrage.

They also go on to state, “When it appears that something is mispriced there is always a reason for it.” Truer words could not be spoken. A lot of traders will find a trade they think they have an advantage on because there is a mispricing. Unfortunately, it is never that easy.

There are two major reasons you will see mispriced options in your option chain. First, a lack of liquidity will cause the market to be very wide and show a lot of false bid/ask spreads. We will cover more on liquidity in the next section.

The second reason is a stale market. If you are looking at quotes afterhours, you could be looking at stale or false quotes. When the market starts the next day the quotes will realign themselves and show proper pricing.

No free lunch means there is no easy money to be made in the stock market. No strategy is without its risks. If it were easy everyone would be doing it.

Traders fall into this trap all the time. The “easy” trade we see all traders run is earnings plays. We are a big proponent of not shorting options during earnings, but despite our best efforts, people still do it.

The appeal to earnings plays is the “crush” in implied volatility immediately following the release of earnings. This automatically leads traders to short options during earnings to take advantage of the drop in implied volatility.

Good concept with the right idea, the downside is that earnings can cause the underlying stock to move in great amounts, much more than predicted. A move too great causes the trade to lose money. The easy answer is to use an iron condor around earnings. Iron condors benefit from a drop in implied volatility but have limited risk. Win-Win.

But, if it were that easy why isn’t everyone doing it?

Because nothing is that easy. The large losses given by earnings will nullify the small gains that you were able to achieve.

If you want to stay in this game for the long term, know that nothing comes easy. No strategy is without its risk.

Beware The Lack Of Liquidity

“Liquidity in trading is an indication of how easy it is to buy and sell an instrument,” said Eric Hale.

When trying to trade in an illiquid market it can often be difficult to get a good fill, and more often you will have to settle getting a price worse than you wanted. A highly liquid market means it is quick to get fills at the price you want. In an illiquid market you are often left with a large bid/ask spread. The bid (the price you sell at) and ask (the price you buy at) are the prices you trade at. When these two prices are further apart it puts you in a hole when you place the trade.

Most option traders are used to trading stock, where liquidity is easier to come by. Finding liquidity in options can be more difficult. There are calls and puts, on every strike, for every expiration in an option chain. You can’t assume that the one option you want to trade will be liquid even if the underlying trades a lot of volume.

You don’t realize the lack of liquidity in the options you are trying to trade. The lack of liquidity will show mispriced options, create larger spreads, put you in a loss before the trade even starts, and make it very difficult for you to close the position once you’re in.

Time Is A Real Risk In Option Trading

When you trade stock, you can hold it forever. If your position is showing a loss, you continue to hold until it, hopefully, comes back and shows a gain.

You are not afforded the luxury of time when you trade options.

An option contract, by its nature, expires on expiration. The time decay to your options will speed us as you get closer to expiration. You can watch a gain in a position turn to a loss just due to time decay. Limited time gives you less opportunity to make decisions on your positions. You cannot simply wait to see if your position comes back, and you cannot hold onto a gain forever. You must decide when to take your winners, cut your losers, and how you plan to adjust your positions, rapidly.

When you purchase stock, you go into the position knowing you’re not going to lose it all. Most companies are not going out of business, even when they do their stock price won’t go to $0 right away. It is very difficult to lose your entire investment.

Not true of options. If you position hasn’t worked out by the time you hit expiration you could be faced with a complete loss of capital for that position.

Conclusion

It is unfortunate that brokerages cannot hand out more appropriate pamphlets that describe the real risks of options. While it is important to know the Tax Implications, Transaction Costs, and Margin Requirements of your trades it is more important to understand what you are doing with your money.

The number one risk to all option traders, regardless of experience level, is a lack of knowledge. It’s too easy to get into a situation that you are unprepared for.

Being unprepared leads to rash decisions based on emotion, and that is a recipe for disaster.

When it comes to a skill, especially one where you win and lose money, never stop perfecting your craft.

What is your biggest risk in options trading? Tell us in the comments...

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"Last year The Option Prophet absolutely transformed my trading account from one where monthly gains were often uncertain and unpredictable into one where a steady monthly income stream through OTM credit spreads bought amazingly steady and consistent growth."

-Andrew B. 

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