Risks of Options Trading

 

How to Turn the Risks of Options Trading to Your Advantage

With any business venture there are always risks - and the risks of options trading are no different. Understanding these risks is crucial to successful trading. In fact, launching boldly into the world of options trading without knowing what you're up against, is like a business without a strategy or sense of direction.

If you want to make a regular income from option trading you have to approach it with the mindset of a businessperson. You have to do your SWOT analysis - strengths, weaknesses, opportunities and threats. This article is primarily about the "weaknesses and threats" aspect.

Enemy Number One - Time Decay

Options are unlike any other derivative financial instrument in that their value decays with the passing of time. During the final 30 days of an options life, its value decays at a much faster and more exponential rate than in all its previous life. You need to be aware of this, the most notorious of all the risks of options trading, and use it to your advantage when implementing your option trading strategies.

If you know who your enemy is, you can not only avoid the dangers of approaching it the wrong way, but in the world of options trading, you can also turn this enemy into your best friend.

One of the great advantages of options trading is that you can not only BUY option contracts, but also create new ones out of nothing and SELL them to the market. We call the 'buying' end 'going long' while the 'selling end' is 'going short'. Most of the risks of options trading fall into the lap of those who 'go long' options, due to the disease of time decay.

If you buy options in the hope of selling for a profit, you need to feel sure that the underlying stock, commodity of whatever, will move to your desired target reasonably quickly, otherwise time decay will eat into your profits. There are ways to minimise this, such as buying "deep-in-the-money" options, where most of their value is "intrinsic value" and less "time value". Another alternative is to purchase long-dated options, i.e. with an expiry date at least 90 days away. This will give you more time to be right and provided they are 'in-the-money' will be less affected by time decay.

Your Enemy Becomes Your Friend

So how can you use time decay to your advantage and minimise the risks of options trading? We have already mentioned that you can SELL (go short) options contracts as well as buy them. This allows the trader to construct combinations of long and short positions in a way that use time decay to your advantage. It is well known that on average, 85 percent of options contracts expire worthless. So that means that if you're on the selling end of the deal, your average risk is reduced from 85 percent to the remaining 15 percent who have sold those contracts.

 

There are a number of option trading strategies which allow you to do this, such as credit spreads, butterfly spreads, iron condors, ratio spreads and covered calls. We describe these in more detail on other pages at this site. Feel free to browse around and discover the many ways you can use 'short' options to reduce the risks of options trading.

Non-directional Trading

Another risk, which is not limited to option trading, is the need to be able to predict the future direction of the underlying market in order to profit. But did you know that there are option trading strategies such as the straddle or options strangle, which allow you to effectively take a bet both ways. You don't care which way the market moves, as long as it goes somewhere within a short space of time. The run-up to an upcoming earnings report is one of the best times to implement this strategy, as markets are anticipating the impending news.

Range Trading Strategies

Since time decay is "enemy number one" among the risks of options trading, it is at its worst when market price action is going nowhere. Sideways trending markets can kill an option's value very quickly. But if you're on the selling end of such a contract, it is where you make your profit. There are a number of option range trading strategies you can take advantage of which are also outlined on this site.

The risks of options trading need not be feared

if you know how to handle them. Options are very flexible in that positions, once entered, can also be adjusted as you see market price movements taking shape. Even losing positions can be turned into winning ones.

 
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