Like all tradeable products, options involve risk. Understanding the risks of any tool is important before using it, especially when you are considering using the tool in your portfolio. In this article we’ll explore the risks of trading options.

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Exposure or Positional Risks

In options trading, there are different risks depending on the position you take. When you buy a call or a put, the maximum risk is losing the money you paid to own that option, known as the premium. That’s right – if you buy a call or a put, you are risking only the money you paid to purchase it. Let’s take a closer look at these and a few other position risks.

· Buy a Call or Put: The maximum risk exposure of long options positions, i.e., when you buy puts or calls, is limited to the premium, or price, you paid for the options contract.

· Sell a Call or Put: When you sell puts or calls, you have the opposite risk exposure of long positions. The maximum risk exposure is significant when selling puts since the price of the underlying can go to $0. The risk is unlimited for short calls since the price of the underlying can increase indefinitely.

· Combination Positions/Options Trading Strategies: When you begin trading combinations and quantities of options with the same underlying but different strikes or expiration dates, you enter the world of complex options trading strategies. Each combination you trade creates different and more complex risk and reward profiles at expiration, unique to that specific strategy. Click here for more informatiom.

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Early Exercise & Assignment Risk

Stock options are American-style options. As a buyer of the stock option, you can exercise your option any time at or before the contract’s expiration date. Should you decide to exercise early, the seller of the option may face the risk of assignment. Assignment is the organized process conducted by the Options Clearing Corporation that randomly matches buyers who exercise options to the sellers that sold them. If assigned, the option seller is obliged to deliver shares to the buyer. The seller would no longer be eligible to collect the dividend payment for those shares. If the seller doesn’t own the shares at assignment, the seller has to acquire shares in the market at whatever price they are trading at.

Index options do not have early assignment risk because they are typically European-style options; they cannot be exercised before their expiration date. Additionally, index options settle into cash instead of shares at expiration, so again, there is no risk of assignment when trading an index option.

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Liquidity Risk

An option’s trading activity is measured through its trading volume. Volume quantifies how many times the contract is traded in a day. Like stocks, options that trade actively, or have a high trading volume, are said to be liquid or have liquid markets. In this context, liquidity describes how easy it is to enter (trade in to) or exit (trade out of) an options position. If volume is low, markets are considered illiquid. Illiquidity is a risk no matter if you are trading options, stock, futures, or other products because a lack of liquidity may mean it is more difficult to get into the position or out of it (convert to cash) at the price or time you want.

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Considerations

Though not direct risks, there are considerations to keep in mind when trading options. Like we said earlier, knowing a tool’s characteristics is an important step before making any trading decisions.

Price Sensitivities

The value of an options contract – its price – is sensitive to different factors. Risk measurements, known as the Greeks, quantify just how sensitive the option’s price is to:

· A move in the underlying asset’s price (Delta)

· A move in the implied volatility (Vega)

· A change in the risk-free interest rate (Rho)

· A change in the time to expiration (Theta)

Traders use these measurements to understand the effect each factor has on an options position’s profit and loss prior to expiration.

For a complete review of all potential risks, please read the OCC’s Characteristics and Risks of Standardized Options (October 2021).

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Disclaimer: Cboe and Webull are separate and unaffiliated companies. This content is provided by Cboe and does not reflect the official policy or position of Webull. This content is for educational purposes only and is not investment advice or a recommendation or solicitation to buy or sell securities.