Options trading is a secret weapon of investors/traders. You can easily see returns in the range of 2000% overnight if you know what you’re doing. However with great gains comes great risks. This article is here to explain what you need to know about the risks and benefits to engaging in options contracts.
Simply put, options contracts give you the right to buy or sell a fixed amount of shares/stock by a future date. Instead of buying 2000 shares you can simply buy 20 contracts which gives you the same selling and buying power. However since you don’t own the shares, only the right to buy/sell them by a future date, every day you hold that ‘contract’ to sell the shares you lose money. Options contracts can give you the ability to see absolutely massive returns and several people have become millionaires through them.
Here at Chronohistoria I teach people how to generate above normal market returns (alpha) in their portfolios. I routinely publish articles on investment research, methodologies, and tips/tricks on the trade. There is a free newsletter if you want to sign up to remain up to date on everything investing.
Let’s jump right into the article: Options Trading: The Risks and Benefits In Options Contracts.
Options Trading Simply Explained
Before we can even begin to talk about the risks and benefits to options trading we first need to define what options trading actually is.
An option contract is just a contract that gives you the right to buy or sell 100 shares at a fixed price in the future. When you buy an option contract you are giving someone money to reserve their buying or selling power for a future date. (source)
Options contracts are an amazing tool that can give you the edge you need in the market. Further, they allow you to do some crazy strategies such as iron condors. An iron condor is a directionless trade where you can make money if the stock goes up or down, it does not matter. (If you want to know more I wrote up an entire article on iron condors, click here)
All options contracts have expiration dates. Every day that you hold an options contract in your account it becomes worth less. This is called theta decay. As options contracts age the likelihood of the underlying stock price shifting gets smaller, which means the contract to buy or sell options contracts becomes worth less.
All you have to remember about options contracts is that they give you the ability to multiply your potential earnings. Further they decay over time.
Risks In Options Trading
There are 5 major risks in options trading: theta decay, naked options, capital requirements, 100% loss, and after hours assignment.
Knowing how each one of these risks impacts your portfolio will set you up for success. At the end of the day options contracts are just another tool in the traders/investors toolbox. Once you understand them you realize how valuable they are to generating massive returns. (article on Islamic banking being impacted by the addition of options contracts over time)
Risk 1: Theta Decay
Options contracts are not investments. Every day that you hold an option contract in your portfolio you will be losing money (unless you sold it). This is called theta decay, and it stands for time decay within a security over time.
If you think that a stock is going to explode and you buy an options contract to capitalize upon it you better be right on the timeframe. If you’re not then you run the risk of just throwing money away as the contract will expire before the event happens that drives the stock’s price upwards.
Theta decay is a huge killer in options portfolios, it’s a major risk. When you buy an option contract you are fighting against time constantly.
Risk 2: Selling Naked Options
Selling naked options is one of the major risks to options trading. If you’re not careful then you can end up owing hundreds of thousands of dollars to your broker.
This is because when you sell an option you are giving the person who bought it the right to sell you 100 shares at a fixed price in the future. In return they will give you a fixed amount of money, called the premium of the option. A naked option is called naked because there is nothing protecting you from losing money on the position.
Selling naked options does have strategies associated with it. However if you don’t know what you’re doing you should stay away from naked selling of options due to the inherent risk present in them.
Risk 3: Capital Requirements
To engage in options trading you typically need to have a margin account and have enough capital to secure the option contract. This depends upon your broker because they are held responsible by FINRA for regulating options within their clients accounts. (source)
Some brokers such as TD Ameritrade want to see a $2,000 minimum to engage in certain options trading strategies. This is because if the client account messes up something the broker can liquidate the clients positions to cover the bad option trade. (Source)
For some people putting up capital to even start trading options contracts is a risk. Because of this most people shy away from options and stick to shares. However I feel as though learning how to trade options is a tool that everyone should know how to use.
Risk 4: 100% Or Greater Loss
Options contracts are incredibly risky. They are not considered investments because no matter what they will decay with time. In order for a position to be considered an investment time must work in favor of the position.
All option contracts come with a 100% or greater risk. If your selling options contracts then your total risk is substantially higher than 100%, sometimes in the range of 1000%. If your buying options contracts then typically your maximum risk is 100%.
Options contracts are not good investments. However they are great tools to grow an account if you know what you are doing. It’s very important that you understand everything about an option contract before you open a position or else you run the risk of losing 100% of your capital.
Risk 5: After Hours Assignment
This risk is a hidden one most people don’t know about. Options exchanges have until 4:30 pm EST to submit assignment orders. That means that someone can assign your option contract after the market closes if they are fast enough. (source)
This would only happen if your option went in the money and you were not paying attention to it. However if you do get assigned after hours then you would be at risk of fulfilling your end of the contract. If you have to buy 100 shares then that means that you’re buying 100 shares after hours, which could cause huge price movement, and thus massive loss.
Further, if your options contracts were set up for a covered call or another advanced strategy then that means you would not be covered. Essentially any option spread is at risk of being a naked option contract if exercised between 4:00-4:30 pm EST on the expiring day.
In order to mitigate this risk you just need to be on top of price movements on the stock. I normally close my option positions near expiration and never let them fully expire.
Benefits In Options Trading
Options trading has 3 major benefits: massive capital growth potential, advanced strategies, and hedging ability.
This is why everyone should understand options trading. It’s just another tool that you can use to generate additional return on a portfolio or hedge a position with. Simply put, everyone should understand how options trading works and learn when to use it.
By not learning options trading you are significantly limiting your potential revenue.
Benefit 1: Massive Capital Growth Potential
Options contracts give you the ability to maximize your potential return from a trend in the market. If you know that a stock will do something by a certain date and that this is going to cause the stock to explode you might as well put your money where your mouth is and get an option contract.
Its not uncommon to see overnight returns in the range of 200-1000% if you know what you’re doing. Granted this is not a daily occurrence but sometimes opportunities do arise. When you get the opportunity you need to take it. That’s how you generate huge ROI’s on portfolios.
On a stock you might only get 20% out of a good move. With that same price movement you will get a huge ROI of 100% in options trading. That is 5 times more money for the same position.
Benefit 2: Advanced Strategies
Options trading allows you to employ advanced strategies on stocks. You can make money if the stock goes up or down. Do you think that a stock will trend sideways and not move at all? There is a strategy for that.
How about if you don’t know which way a stock is going to move, you only know that it is going to explode up or down (at earnings for example). With options there is a way to create a trade that will make you money regardless of which way the stock’s price goes.
You can also make money just by holding contracts in your portfolio. Remember theta decay and how it slowly lowers the value of an options contract? Well you can set up an options strategy that will pay you out overtime.
Benefit 3: Hedging Ability
Hedging is the secret weapon of professional traders/investors. Hedging is simply designing a trade so that even if it fails you will still make money. Normally hedging is very hard but with options you can easily create a hedge that will cause you to earn money and protect your investment.
This is one of the main benefits of options trading. The ability to hedge an investment in the market. By practicing hedging you will be able to sleep easy at night knowing that your investment is protected.
If you’re interested in learning more about hedging and how it works I wrote up an entire article on the topic. (Click here for the article)
There you have it; an article that goes over the benefits and risk to options trading. It’s very important that you understand everything there is to know about options trading because it’s just another tool to help you generate more money.
I use options trading all the time to compliment my already good positions. Once you know what you’re doing, a whole new world of investing opportunities is opened to you. That’s why I always recommend that people start to learn about options trading, both the risks and benefits.
Here at Chronohistoria I teach people how to generate above average market returns on investments. I routinely publish articles going over investment research, methodologies, and tips/tricks of the trade so that you are better prepared.
Feel free to sign up for the free newsletter to remain up to date on all things investing.
Further you can check out some of the other articles below.
Here is how long it really takes to learn how to trade options. Most people think they can jump right in however that’s dangerous.
There are 3 things that could happen if nobody buys the company’s stock. Make sure you are aware of these effects so that you can be ready.
Global Macro is far from dead. Here are 5 tricks to help you generate above average returns in your global positions.
Until we meet again, best of luck in your investing journey.