Risks with Trading Options
A tremendous opportunity awaits anyone who considers including options in their portfolio. When you review the broad range of possible uses for options, it becomes clear that they can serve the interests of a wide spectrum of investors. At the same time, you need to recognize the broad range of risks in option investing, and also to remember the complexity of income tax rules. As an options trader, your status as a stock investor could be affected by the option-related decisions that you make.
You will ultimately decide to employ options only if you conclude that they are appropriate, given your own financial and personal circumstances.
Identifying the Range of Risk
In any discussion of risk, a starting point should be a discussion of information risk. Are you getting valid information? If you have listened to analysts in the past, or followed the crowd in deciding when to buy or sell, then you have been operating with the wrong information. But if you have picked stocks carefully and based your choices on analytical criteria (fundamental, technical, or a combination of both) then your decisions can be made based on facts rather than on the more common standards: rumors, opinions, and unsupported claims. Even the analysts' "target price" announcement is arbitrary and baseless. The popular practice of identifying earnings ranges and target price ranges has deceived many investors into making decisions for all the wrong reasons.
Beyond the problems of information risk, you will also want to remain vigilant and watch for the whole range of risks you face whenever you are in the market. Options address the entire spectrum of risk tolerance profiles and can be used in combinations of ways to supplement income, insure other positions, leverage future long positions, or modify exposure to loss. To determine how to use options in your portfolio, first go through these three steps:
Study the full range of possible option strategies. Before opening any positions in options, prepare hypothetical variations and track the market to see how you would have done. Become familiar with valuation and changes in valuation by watching a particular series of options over time.
Identify your personal risk tolerance levels. Before picking an option strategy, determine what levels of risk you can afford to take. Set standards and then follow them. Be prepared to abandon outdated ideas and perceptions of risk, and continually refresh your outlook based on current information.
Identify and understand all of the risks associated with options trading. Consider every possible risk, including the risk that a stock's market price will not move as you expect, or that a short position could be exercised early. In option investing, risk levels depend on the position you assume. For example, as a buyer, time is the enemy; and as a seller, time defines your profit potential.
The risk in each and every option position is that the underlying stock will do one of two things. It may move in a direction you didn't expect or want; or it may fail to move enough for a position to be profitable. A study of profit and loss zones before opening positions is a smart tactic, because it helps you to define whether a particular decision makes sense.
Margin and Collateral Risks
You may think of margin investing as buying stock on credit. That is the most familiar and common form. In the options market, margin requirements are different and margin is used in a different way. Your brokerage firm will require that short positions be protected, at least partially, through collateral. The preferred form of collateral is ownership of 100 shares of stock for each call sold; if you are short on puts, your broker will require cash or securities to be left on deposit to provide for the cost of stock in the case the short put is exercised.
Whenever you open uncovered short positions in options, cash or securities will have to be placed on deposit to protect the brokerage firm's position. The level required is established by minimum legal requirements, subject to increases by individual brokerage firms' policies. Any balance above the deposit represents risk, both for the brokerage firm and for you. If the stock moves in a direction you do not desire, the margin requirement goes up as well. In that respect, margin risk could be defined as leverage risk.
Personal Goal Risks
If you establish a goal that you will invest no more than 15 percent of your total portfolio in option speculation, it is important to stay with that goal. This requires constant review. Sudden market changes can mean sudden and unexpected losses, especially when you buy options and when you sell short. Getting away from the goals you set is all too easy.
Your goal should also include identification of the point at which you will close positions, either to take profits or to limit losses. Avoid breaking your own rules by delaying, hoping for favorable changes in the near-term future. This is tempting, but it often leads to unacceptable losses or missing a profit opportunity. Establish two price points in every option position: minimum gain and maximum loss. When either point is reached, close the position.
Smart Investor Tip
Options traders, like gamblers, can succeed if they know when to fold.
Risk of Unavailable Market
One of the least talked about risks in any investment is the potential that you will not be able to buy or sell when you want to. The discussion of options strategies is based on the basic idea that you will be able to place orders whenever you want to, without problems or delays.
The reality is quite different in some situations. When market volume is especially heavy, it is difficult and sometimes impossible to place orders when you want to. In an exceptionally large market correction, volume will be heavy as investors scramble to place orders to cut losses. So if you trade by telephone, your broker's lines will be overloaded and those who do get through will experience longer-than-usual delays -- because so much business is taking place at the same time. If you trade online, the same problem will occur. You will not be able to get through to the online brokerage web site if it is already overloaded with traders placing orders. In these extreme situations, your need to place orders will be greater than normal, as it is with all other investors. So the market may be temporarily unavailable.
Risk of Disruption in Trading
Trading could be halted in the underlying stock. For example, if rumors about a company are affecting the stock's market price, the exchange may halt trading for a day or more. When trading in stock is halted, all related option trading is halted as well. For example, a company might be rumored to be a takeover candidate. If the rumors affecting price are true, when the trading halt is lifted, the stock may open at a much higher or lower price than before. As an options investor, this exposes you to potentially significant risks, perhaps even preventing you from being able to limit your exposure to loss by offsetting the exposed side of the transaction. You will be required to wait until trading reopens, and by then it might be too late. The cost of protecting your position might be too high, or you might be subjected to automatic exercise.
A serious potential risk is the individual action of your broker. If you use a discount brokerage or online trading service, you are not exposed to this risk, because the role of the broker is limited to placement of orders as you direct. However, if you are using a broker for advice on options trading, you are exposed to the risk that a broker will use his or her discretion, even if you have not granted permission. Never grant unlimited discretion to someone else, no matter how much trust you have. In a fast-moving market, it is difficult for a broker with many clients to pay attention to your options trades to the degree required. In fact, with online free quotations widely available, you really do not need a full-commission broker at all. In the Internet environment, commission-based brokerage is becoming increasingly obsolete. As an options trader, you may want to consider using an order placement service and moving away from the practice of paying for brokerage services.
Yet another risk, even with online brokerage accounts, is that mistakes will be made in placing orders. Fortunately, online trading is easily traced and documented. However, it is still possible that a "buy" order goes in as a "sale," or vice versa. Such mistakes can be disastrous for you as an options trader. If you trade by telephone or in person, the risk is increased just due to human error. If you trade online, check and double-check your order before submitting it.
Trading Cost Risks
A calculated profit zone has to be reduced, or a loss zone increased, to allow for the cost of placing trades. Brokerage trading fees apply to both sides of every transaction. If you trade in single-option contracts, the cost is high on a per-option basis. Trading in higher increments is economical because the cost of trading is lower on a per-option basis.
This book has used examples for single contracts in most cases to make outcomes clear; in practice, such trading is not always practical because the trading fees require more profit just to break even. A thin margin of profit will evaporate quickly when trading costs are added into the mix.
When you buy and then exercise an option, or when you sell and the option is exercised by the buyer or the exchange, you not only pay the option trading fee; you also have to pay for the cost of transacting the shares of stock, a point to remember in calculating overall return. It is possible that if you're operating on a thin profit margin, it could be taken up entirely by trading fees on both sides of the transaction, so that cost has to be calculated beforehand. In general, single-contract trades involve about one-half point for the combined cost of opening and then closing the option position; so you need to add a half-point cushion to allow for that. The calculation changes as you deal in multiple contracts, in which trading costs on a per-contract basis will be far lower.
Lost Opportunity Risks
One of the more troubling aspects of options trading involves lost opportunity risk. This arises in several ways, the most obvious being that experienced by covered call sellers. You risk the loss of stock profits in the event of price increase and exercise. Your profit is locked in at the striking price. Covered call writers accept the certainty of a consistent, better-than-average return and, in exchange, they lose the occasional larger capital gain on their stock.
Opportunity risks arise in other ways, too. For example, if you are involved in exotic combinations including long and short positions, your margin requirements may prevent you from being able to take advantage of other investment opportunities. You will often find yourself in an environment of moderate scarcity, so that you cannot seize every opportunity. Before committing yourself to an open position in options, recognize how your economic boundaries could limit your choices. You will probably lose more opportunities than you will ever be able to take.
Tax Consequence Risk
In trading options, you need to take great care to ensure that you don't incur unintended consequences. This is as true when it comes to tax liabilities as anywhere else. The potential tax consequences include:
Poor timing of taxable outcomes. You are going to need to perform careful tax planning to maintain control over the taxes due on your portfolio. This includes consideration of both federal and state taxes. Because so many options strategies are only marginally profitable, poor planning could result in new losses once taxes are considered in the overall outcome. For example, a small profit could result in extra tax liabilities, wiping out all of the gain. In this situation, you are exposed to risk while option positions are open, but you earn no profits.
Loss of favorable tax rates. As you will see later in Tax Ramifications in Trading Options, some option positions automatically revert a long-term capital gain (with its lower maximum tax rate) to short-term capital gains (which are taxed at your full ordinary income tax rate). While net investment income is included on a person's tax return, it is often taxed at lower rates (long-term capital gains) or excluded from tax (qualified dividends).
Limitations on deductibility of losses. Some types of advanced options trades are subject to limitations in deductibility. For example, in some cases involving two or more offsetting option positions, a loss portion cannot be deducted in the year incurred, but has to be deferred and offset against the rest of the position (more on this in Qualified Covered CallsâSpecial Rules).
There are some obvious tax advantages to some trades, especially if they are timed properly. For example, if you sell a covered call not due to expire until next year, you receive funds at the time you open the position, but taxes are not applicable until the position is closed, expired, or exercised. But there is much more to tax planning and to tax risk. These tax risks in trading options can be quite complex, especially for anyone not completely familiar with how the tax rules work. Options taxation is exceptionally complicated, so before entering into advanced trading positions, consult with your tax adviser.