Options are known to be risky investments. However, many traders are surprised when they learn that one of the biggest reasons to use options is to reduce risk. Investors interested in using options should understand the risk they are assuming before they attempt to enter into any options transaction. The purpose of this article is to identify and evaluate the three primary types of risks that investors should consider when using these products.

Volatility Risk

Volatility substantially influences the pricing of an option. Option volatility also generates risks for investors. As a result, it is important to identify and evaluate the causes of the risks before making an investment decision.

Liquidity is a key factor of determining volatility. For most options, it is the reason options can be traded without being adversely affected by a wide bid-ask spread. A large spread means that the market is not very liquid, and that the investor will have to cover the spread before making any money. This also assumes that the price moves in your favor, but options with minimal liquidity are subject to being quickly whipped up or down in price because they do not have sufficient number of investors trading them. This volatility can cause quick losses. In most cases, it is best to avoid options that are illiquid. Another general rule to follow is that normally, when the underlying security is liquid the options will be liquid as well.

Another indicator of volatility risk is the total number of option contracts that are currently open, or what is known as open interest. The number representing the open interest represents the number of option contracts that have been traded but not yet liquidated by either an offsetting trade or by exercising the options. As a result, when looking at open interest there is no way of knowing whether the options were bought or sold. In general, the change in open interest helps to determine whether the trading volume is high or low each day. Also, the larger the open interest the more liquid the option. (For related reading, see Discovering Open Interest - Part 1 and Part 2, and Options Trading Volume And Open Interest.)

There are several other measures of volatility that are given "Greek" names. For our purposes, the best one to examine is known as Delta, which measures the rate of change in the option's premium due to a change in the price of the underlying security. Basically, Delta is the amount by which the option's price will change for a $1 change in the underlying security.

For example, suppose that stock ABC is selling at $20 a share. A call option on ABC is selling for $2 and the Delta is 0.75. If the price of ABC shares moves up $1 to $26, then the price of the call option will increase $0.75 to $2.75. Investors who use options to hedge their portfolios use Delta to measure the degree to which the option will offset a move in the underlying security. As a result, Delta is often called the hedge ratio. (To learn more, see The ABCs Of Option Volatility and Getting To Know The "Greeks".)

Risks Faced by the Option Writer and Holder
Writers of options are the ones who create the options contract that is then bought on the exchanges. When you are writing options, you have the obligation to buy or sell the stock should the option be exercised or assigned. When writing an option, investors should ask themselves: "What is the worst theoretical loss I might sustain?" and "Can I afford to lose that much?" To help understand the risks options writers face, let's review some of the most important risks they might encounter.

  1. The writers of call options are required to deliver the stock upon being assigned. Should the price of the underlying stock rise up to or above the call strike price, the option might be assigned. If a writer of a call option does not own the underlying stock (this is called an uncovered call), the investor will have to buy the shares in the open market. The difference in the price at which the stock is acquired and the strike price of the assigned option can be significant, resulting in a substantial loss. If the investor has borrowed stock to meet this contractual obligation, the risk of further losses exists. If the writer owns the underlying stock (this is called a covered call), the exchange will assign the shares to a holder of the call option. The option writer will no longer own these shares. In any case the writer of the option will retain the premium received for writing the call option. (For more insight, see Come One, Come All - Covered Calls.)
  2. The writers of put options are required to take delivery of and pay for the underlying stock upon being assigned. Should the price of the underlying stock fall down to or below the put strike price, the option might be assigned. When assigned, the writer of a put option will be required to buy the underlying stock at that option's strike. By being forced to buy the stock at the strike price, the put option writer may end up paying substantially more than the market price for the stock, incurring a large loss. While the option writer will have received a premium from writing the option, this premium may be substantially less than the difference in the strike price and the market price of the underlying stock.
  3. Writers of covered calls lose the right to the upside in the underlying stock. A covered call writer receives the premium from the option. The call writer is covered by owning the underlying stock. However, if the price of the underlying stock falls, the call writer is only covered by the premium on the option and will still incur the loss in the stock price.
  4. Short option positions are subject to margin calls. Furthermore, margin requirements can change, causing the investor's broker to issue a margin call. As a result, an investor may be required to close out all of his or her position as well as provide additional cash to cover the margin call. (To read more on this subject, check out Margin Trading.)
  5. American style options can be assigned at any time. European style options are only assigned on the expiration date. American style option holders might exercise their options early, such as when the stock is going ex-dividend or the market for the option is illiquid. While it is generally more profitable to sell an option than to exercise it, early writers of options need to be aware of this potential situation. Before they create the option, investors should know when the underlying stock will go ex-dividend and the liquidity of the option market they are considering. (For more insight, read Declaration, Ex-Dividend And Record Date Defined.)

Options holders also face several risks that they should understand before committing to a trade.

  1. If you intend to exercise an option you must be prepared to buy the stock (a call option) or deliver the stock (a put option). Holders of call options that are in the money who have not been closed out or are unable to close out will be required to buy the stock if the options are exercised. For holders of put options, the investor must be able to deliver the underlying stock. If the investor does not have the necessary shares, he or she must have the funds available to meet the contract's obligations.
  2. Holders of options may lose the full value of the premium they paid for the option. Option holders are betting that the option will become profitable within the time frame set by the option. Option holders can avoid losing remaining premium by closing out the long position before it expires. They can also exercise the option. On the other hand, if the investor was using options to hedge an underlying security, the loss of the premium may be acceptable, similar to the cost of insurance.
  3. The closer an out-of-the-money option is to the expiration date, the greater the chance that the investor will be able to close out or exercise with a profit. Time is the enemy for holders of out-of-the-money options. Remember, the only value these option have is their time value, which declines as the expiration date gets closer. If this is the situation, then the option holder should be prepared to lose the entire premium paid for the option. If the investor has acquired a very large position, this can be a significant loss. (For related reading, see The Importance Of Time Value and Understanding Option Pricing.)

The Risk Profile of an Option
Managing risk is all about knowing the potential profits and losses that an investor can expect from a trade. Fortunately, investors using options can use payoff or breakeven diagrams to get a better understanding of the potential for the trade. A payoff diagram shows the potential profit or loss of an option strategy over a continuum of stock prices at expiration. These diagrams can be drawn for any option, or combination of options.

Let's start with call options. The breakeven point for call options is the exercise price plus the option premium. The call option writer's potential profit is limited to the premium received. If the call option writer does not own the underlying stock, the potential loss can be significant. For an uncovered call writer, as the share prices rises above the strike price, it will cost more to buy the shares at the market price should the option be exercised. While options are priced as though they are a single item, the contract is for 100 shares, so you must multiply the option price by 100 to get the price per option. The payoff diagrams below are based on how options are displayed in all trading material. To determine the value of each contract, multiply the price by 100 to get the price for a single option. For all examples below the strike price is $29.

In the diagram below, the call option writer has a limited profit potential limited to the premium received, $100 per option contract ($1 premium x 100 shares per contract). The breakeven point for the call writer is the exercise price plus the premium received, or $30 ($29 + $1 = $30). Commissions are not considered in this example. As long as the stock price remains below 30, the call option writer makes money. Once the stock price moves above 30, the call option writer begins to lose money. If the option writer owns the underlying shares (a covered call), the loss is limited to the rise above 30 in the stock price. If the option writer does not own the shares, the call writer will have to buy the shares at the market price if the option is exercised, which is most likely.

Figure 1

For the investor holding a call option, the maximum loss is the premium paid. However, as the price of the stock rises above the breakeven point, the profit rises. The maximum profit is unlimited: the higher the share price goes, the larger the profit for the option holder.

In Figure 2, the breakeven point for the call option holder is the exercise price of the option plus the premium paid, or $29 + $1.00 = $30.00. As shown in the diagram below, the call option holder will incur a loss as long as the price of the stock remains below $30. As the share price rises above $30, the call option holder makes a profit. Theoretically, the profit is unlimited: the higher the price of the shares, the higher the price of the option.

Figure 2

The breakeven point for put options is the exercise price less the premium. The put option writer's potential profit is limited to the premium received. If the share price falls below the breakeven point, the position turns into a loss. The potential loss is only limited by a fall in the share price to zero.

In Figure 3, the put option writer is limited in his or her profit potential to the premium received ($100 per option contract). The breakeven point is the exercise price minus the premium received, or $29 - $1 = $28. As long as the share price remains above the breakeven point, the put option writer has a profitable position. Should the price of the shares fall below the breakeven point, the put option writer will begin to lose money and may be required to buy the underlying shares at the strike price ($29) - when the shares are selling for less.

Figure 3

For a put option, the most the holder can lose is the premium paid. For all put options, the breakeven point is the exercise price less the premium. For the put option holder, the more the share price falls below the breakeven point, the larger the holder's profit. The maximum profit is the exercise price less the premium paid.

In Figure 4, the breakeven point for the put option holder is the strike price minus the premium paid, or $29 - $1 = $28. As shown in the diagram, the most that the put option holder can lose is the premium paid. The more the price of the shares falls below the breakeven point, the greater the profit for the put option holder. The potential gain is limited by the fall in the price of the shares to zero.

Figure 4

Options offer investors ways to enhance their leverage over an underlying stock. This also can increase the risk faced by the investor. Knowing the risks and how to assess them is an important step to successfully using options to generate consistent profits and hedge an existing portfolio.

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