Why is Options Trading considered risky?

Short Answer

Options trading is different from traditional share trading in many ways. Trading in options includes multiple factors like high leverage, delivery obligation on the date of expiry, unlimited loss potential, etc. All these factors make trading in options riskier.

Detailed Answer

What is Options Trading?

Options are derivatives tools that can also be considered similar to a contract or a promise between the buyer and seller of the options. An option buyer has the right to buy or sell the underlying assets on the date of expiry. On the other hand, an option seller bears the obligation to transfer the underlying to the option buyer on the date of expiry.

Options are considered as a separate asset class, where you can trade and generate some money. Option prices are determined by some external factors like volatility as well as some pre-defined parameters like the 'Options Greeks'. An option buyer or seller can buy and sell these options to generate a hedge on their investments or speculate on the price movement on them.

How is it different from common share trading?

Now that you know what is options trading, let's understand how it is different from share trading.

  • Whenever you buy and sell a stock for more than a trading day, you take delivery of the asset and sell it later. Although you can short a stock on an intraday basis, it is not possible to carry forward your shorts in traditional equity investing. Whereas you can implement these with the help of options.
  • Options are also leveraged, unlike traditional equity shares. You cannot purchase the shares of Reliance or ITC with leverage but you can buy a Call option of these shares with the help of leverage. With options, you can employ leverage of 10 to 20 times in some cases. An option buyer pays the premium, whereas an option seller collects the premium.
  • The settlement on options happens on the last Thursday of every week/month. You can hold on to your option contracts without any excess charge. As options are mere contracts, you don’t have to buy/sell the underlying until the date of expiry.

What is Options trading considered riskier?

By now you must have put together a clear picture as to what are options and how they are different. Now, let's find out why they are considered riskier.

1. High leverage

The leverage in options can be a boom or a bust. In a favorable scenario, you can create extremely high returns on your capital. But at the same time, options contain the potential to erode your capital completely if the trade goes against you. Often traders take on extremely high leverage and end up losing their complete capital in a particular trade.

2. Potential for unlimited losses

Options trading have two aspects. One is options buying and the other is options selling. The buyer of an option pays the premium whereas the seller of the option collects it. The maximum profit potential of the buyer of the option is unlimited against a limited risk to the premium paid. Whereas an options seller bears an unlimited risk. If adverse market conditions result in extremely high option prices, the option seller has to either bear the loss or square off the position by realizing the loss. In both ways, if you sell a naked option, the maximum gain represents the premium collected whereas the maximum loss is uncapped.

3. Obligation for exchange of the underlying asset

Options trading involves another aspect of exchange that is absent in equity trading. Both the options buyer and seller have to exchange the underlying on the date of expiry. Although the option buyer doesn’t have the obligation to give/take the delivery of the underlying shares. An option seller has the obligation to exchange the underlying on the date of expiry. In case, you sell a stock option and hold it till the date of expiry, you will have to either buy or sell the required number of the underlying shares. For this, you will have to shell out a minimum of Rs 5-7 lakh. This could be a problem for many small traders who might not have this kind of liquidity. Due to this, option selling or buying is considered a high Capex investment and small traders should trade in them carefully.

Conclusion

By looking at some of the key risks involved in options trading, it is clear that options trading is a high-risk high-reward proposition. Although you can reduce the overall margin requirement by taking hedged positions, still you should not begin options trading unless you have sizeable capital and sufficient expertise in the field.

Tagged With: options tradingdelivery obligationoptions sellingoptions buyingcall optionput option
Categories: Option Trading
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Related FAQs

What is Call Option and Put Option?

Options are a form of conditional derivatives policy that allows the holder to buy or sell the key asset at a fixed price before or after the agreement expires. The two most impactful options are Call Options and Put Options.

Why is Options Trading more risky on the expiry day?

Options trading involves many factors such as Options Greeks. Options Greeks like Delta, Theta, and Gamma have the most impact on Option prices towards the end of the expiry. The option premiums are impacted highly by Gamma and Delta on the day of expiry. Learn more about Options greeks and how they impact option premiums.

How much money is required for Options trading?

Options trading involves two aspects. One is options buying and the other is options selling. To buy an ATM option you will require around Rs 10,000 to Rs 25,000 per lot for an Index or stock option. On the other hand, you will require close to Rs 95,000 to Rs 1,50,000 for selling 1 lot of index option. These amounts change with respect to the time remaining to expiry and other market conditions.

Are puts riskier than calls? Risks to Consider

Puts are Calls are both risky in their own terms. For calls it is necessary to make decisions well as there are chances that you make loose the premium. In case of puts it is important to strategize the the options well.

Which is the best time frame for Options Trading?

Options Trading is a risky business and options traders have to look at various parameters before taking a trade. Choosing a time frame is one of the factors in options traders. Both option Buyer and Sellers use different time frames to trade. Let's see which time frame is most useful for options buying as well as selling.

What is Uncovered or Naked Options Trading?

Naked or Uncovered Option trading is a type of trading/speculating where a Call or Put option is bought or sold by different individuals at the same time expecting different price direction movements. Naked Option trading is a Zero-Sum game which means that the Profit for one is a Loss for the other individual.

What to not do when trading Options?

Options trading offers many options to traders, investors as well as hedgers. There are some common mistakes that option traders commit. Five of the most common mistakes are, taking too much leverage, not having a pre-defined stop loss and target, acting on tips on social media, adhering to buying options, and taking unhedged trades.

Can I trade in US Options from India?

Yes, individuals can trade US options from India. There are many platforms as well which allows the individuals to trade internationally, it just depends on them what they are comfortable the most with and prefer trading from.

How does Gamma affects risk in Options trading?

Gamma is an Option Greek that affects the change in the Option premiums. Options traders need to know about Gamma and some other Option greeks to calculate the risk per trade. The effect of Gamma becomes stronger as the expiry approaches. The Gamma also increases as an Option becomes ITM or ATM from OTM. Know more about it here.

How much money do you need to begin Options Selling?

Option Selling requires large capital. Due to this many small retail traders resort to option buying where the margin money required is very less. Although with various strategies you can reduce your overall risk and margin required in Options selling. Know more about how much money is required to start option selling. The difference in the margin money required for selling a naked Option vs Selling a Hedged Option here.