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 the Best strategy for Options Trading?

There are many complex Option Trading strategies out there but the most profitable are some of the simpler ones. The top 3 of them are Long & Short Straddles, Long & Short Strangles and Bull/Bear spreads.

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Which is the simplest options strategy for beginners?

Options trading can be done in diverse ways. You can trade Options in unhedged or Naked positions as well as use multi-leg strategies to limit the losses. An endless combination of options can be used to put together a strategy. This can get complex sometimes. But many simple Option strategies can be used by Beginners. More of such strategies are discussed here.

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 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.

What is the minimum amount required for Options Trading in India?

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What is an Option Spread? Meaning, Types & Examples

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What will happen if I don't square off my Option contract on trading day?

If you forget to square off your option contract at the end of the day, the contract will automatically be settled if it's an in-the-money option. The contract would be settled on the expiry date and will be sold at the market price.

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