The risks of options need to be weighed against their potential returns.

Many options strategies are designed to minimize risk by hedging existing portfolios. While options can act as safety nets, they’re not risk-free. Since transactions usually open and close in the short term, gains can be realized very quickly. This means that losses can mount quickly as well. It’s important to understand all the risks associated with holding, writing, and trading options before you include them in your investment portfolio.

Understanding the risks of the option

Like other securities — including stocks, bonds, and mutual funds — options carry no guarantees, and you must be aware that it’s possible to lose all of the principal you invest, and sometimes more. As the holder of an option, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk.

For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise. However, since initial options investments usually require less capital than equivalent stock positions, your potential cash losses as an options investor are usually smaller than if you’d bought the underlying stock or sold the stock short. The exception to this general rule occurs when you use options to provide leverage: Percentage returns are often high, but it’s important to remember that percentage losses can be high as well.

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Why options are wasting assets?

One risk particular to options is time decay, because the value of an option diminishes as the expiration date approaches. For this reason, options are considered wasting assets, which means that they have no value after a certain date. Stockholders, even if they experience a dramatic loss of value on paper, can hold onto their shares over the long term. As long as the company exists, there is the potential for shares to regain value. Time is a luxury for stockholders, but a liability for options holders.

If the underlying stock or index moves in an unanticipated direction, there is a limited amount of time in which it can correct itself. Once the option expires out-of the-money it is worthless, and you, as the holder, will have lost the entire premium you paid. Options writers take advantage of this, and usually intend for the contracts they write to expire unexercised and out-of-the-money.

Owning stock vs owning options

It’s also important for you as an options investor to understand the difference between owning options and owning stock. Shares of stock are pieces of a company, independent of what their price is now or the price you paid for them. Options are the right to acquire or sell shares of stock at a given price and time. Options holders own the rights to what’s sometimes described as price movement, but not a piece of the company.

Shareholders can benefit in ways other than price movement, including the distribution of dividends. They also have the right to vote on issues relating to the management of the company. Options holders don’t have those benefits and rights.

Understanding longs and shorts

In investing, the words long and short are used to describe what holders and writers, respectively, are doing. When you purchase an option, you are said to have a long position. If you write an option, you have a short position. The same terminology is used to describe ownership of stock. You can go long on 100 shares of XYZ by purchasing them, or go short by borrowing shares through your brokerage firm and selling them.

How your gains are taxed?

The tax issues associated with options transactions can be complicated. Any short-term gains you realize on securities you’ve held for less than a year are taxed at a higher rate than long-term gains, or gains on securities held longer than a year.

Since most options are traded or exercised within a matter of weeks, in general, the gains you realize will be short-term, and may be taxed at a higher rate. But some investors can use short-term losses from options to offset short-term gains on other securities, and reduce their taxes. Since options contracts can be diverse, the applicable tax rules depend on the particular option, the type of underlying security, and the specifics of the transaction. It’s important to consult a professional tax adviser before you begin to trade options, in order to understand how different strategies will affect the taxes you pay.

In conclusion

Since options are wasting assets, losses and gains occur in short periods. If you followed a buy and hold strategy, as you might with stocks, you’d risk missing the expiration date or an unexpected event. It’s also important to fully understand all potential outcomes of a strategy before you open a position. And once you do, you’ll want to be sure to stay on top of changes in your contracts.

  • Since an option’s premium may change rapidly as expiration nears, you should frequently evaluate the status of your contracts, and determine whether it makes financial sense to close out a position.
  • Regularly check OCC’s website for any pending corporate actions, such as splits and mergers, that might prompt contract adjustments.

What Are the Risks of Options Trading? by Inna Rosputnia

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