Option Trading Risk

In the world of investing, option trading risk is not an exceptional case as when it comes to stock market investment, there are some “dangers” or “risks” involved in each segment. 

So, today let’s talk about the risks associated with Options trading along with the ways to overcome them.

Before moving to the main topic, let us quickly understand what is Options trading, its types, and how does option trading works?

As we all know that the investment world is full of equity, commodity, currency, IPO (also known as Initial Public Offering), PMS or Portfolio Management Services, derivatives, and a lot more! 

From the derivatives segment, emerges Futures and Options. Both types of trading are contracts involving two parties who get involved in buying or selling an asset at a predetermined price and date in the future. 

However, in the former, the two parties are obligated to exercise the contract while in the latter the two parties have a right but not obligation to execute a trade at a pre-determined price, known as Strike Price. 

Generally, there are two different kinds of options trading- Call Option and Put Option, designed for sellers and buyers to take advantage of options trading during complex situations and to minimize the losses.

So it is the right moment that we should begin with the risks or “dangers” associated with Options trading. 

What is the Risk of Options Trading? 

Options trading is one of the complex trading types that gives traders a chance to make a profit even in the bearish market condition. But making a profitable trade involves too much risk as well.

If you are into options trade, then it becomes important for you to consider those risks to avoid making losses. So, when it comes to option trade, there is not only one risk but multiple dangers associated with options trading.

Furthermore, there are differences in the kinds of risks as well when you compare Option Trading Vs Stock Trading. You need to consider this aspect as well, as you pick one of the formats for your trading.

Want to know what are those risks, here we are with the best piece of information that helps you in executing beneficial trade right from the beginning.

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Loss in Option Trading 

The most prominent risk involved while investing in Options is the financial losses that an investor suffers at certain times. Along with this, if you are a beginner-level investor then the chances of your losing money are apparently higher.

This is due to the fact that more time is required to understand option trading basics. With time and practice, an investor can learn how to avoid the risk of financial losses associated with options.

Also, understanding when and how to buy and sell stocks while doing options trading is also essential, otherwise, a greater chance of losing money can prevail.

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Let us understand it with the help of an example-

Seema buys 2000 shares of ABC company with each share costing Rs. 355. She is seeing a potential profit but at the same time wants to minimize the risk and therefore enters into the options contract. 

Since the stock was bullish therefore she picked the strike price Rs. 360 at Rs. 100 per share and entered into the contract expiring in 2 months with Ajay who is predicting a rise in the price of the stock. 

For this, Seema paid a premium amount to Ajay thus gaining a right but not obligation to exercise the contract. 

After a while, the market faces a bearish condition and the stock prices fall to Rs. 300 per share. Now here Seema who had paid a premium amount can push Ajay to buy stock thus making a profit while on the other hand, Ajay faces a loss of Rs. 60 per share. 

Thus, you can say that options trading is a zero-sum game in which either of two parties has to face loss on the execution of the trade. 

So, in this way, the chances of getting a financial loss in the stock market are comparatively higher.

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Option Trading Strategies

If you expect to make profits in this complicated trading segment then having information as well as having stock market education on the same is highly important. 

In this way, you will be required to have a deeper understanding of the option trading strategies that can be useful to tackle various situations and trends of the market. 

Options trading also acts as a risk-management strategy. Hence, you must be familiar with concepts related to it. 

Some of the strategies or techniques related to Options Trading can help you to overcome the bearish condition, while some will be useful during the bullish market. 

Also Read: 7 Common Options Trading Mistakes

In addition to this, on certain occasions like indecisive market state, various option trading strategies can be highly beneficial. 

So, knowing and understanding these strategies in practical terms is very important. To achieve the same, one can also opt for Virtual Trading. 

Besides this, the worst-case scenario would be to do guessing and you should definitely avoid it! 

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Liquidity in Options

Liquidity is definitely a major risk that most options traders face while investing in the stock market especially when there are several types of options and there are only a few that are actually effective. 

The rest of the option types have limited prominence and observe liquidity challenges as the number of traders and investors using them is also quite less. 

So, yes! Liquidity is a greater risk while using options. 

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Option Trading Cost

When you opt for options trading, there is a concept named spread that comes to light. Most of the time, sellers and buyers have different concepts and requirements when it comes to fixing a stock price. This expense or amount can be higher as well as lower, depending on your discussion.

Apart from this, if a buyer chooses options trading then he will be required to pay a premium along with trading charges. 

Although the amount is low, however depending on the trading price and volume it can arise too.

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Option Trading Time Value

Options are generally used for a shorter duration such as a few days, several weeks, or a month. In this short duration, it is very rare that a stock or share price will rise dramatically. Thus, resulting in low chances of any profit-making as the stock prices generally need a long time to show a sudden swift.

So, coming in an option contract when you pay premiums and trading fees you don’t even get an attractive profit. 

This is surely one of the biggest option trading risk. Due to lesser and short time, the expectations related to the trading do not meet easily. 

However, a long-term investment gets enough time to manage his stock or securities and earn profits as the duration is a bit long and chances of higher fluctuations are much higher in this trading. 

So, these were the common 5 option trading risks that every investor must be aware of before stepping into the options markets. Apart from these risks, there are other factors too such as high leverage, higher upfront payment, low profits, liquidity scale is must lower, and many more! 

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Option Trading Risk Assessment 

There are different features available for the option traders in the stock market so that they can determine their profit and loss (P&L) measurement. After or before exercising options, an option trader can analyze his risk by considering several factors. 

On one side, options trading can act as a risk management technique, and on other hand balancing this risk disparity is also vital. 

There are four major major assessment factors, which are also known as ‘The Greeks’ that must be considered while measuring option trading risks and these are given as below-

 

Now, let’s understand each of these “The Greeks” in a detailed way.

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Delta 

The first factor that helps in determining the options trading risk is Delta. It is the calculation of the difference in an option’s value (that is, the premium of an option). This happens due to the changes observed in the underlying asset or security. 

• Delta is a calculation of the difference in the value of delta goes from – 
  • 100 to 0 for puts (- 1.00 without the decimal move)
  • 0 to 100 for calls (-1.00 without the decimal move)

Do you know that Delta values nearer to 1.00 or – 1.00 give the most significant levels of foothold. 

• Typically, the Put Option creates a negative delta since they have a negative relationship with basic security. You might have seen that premium in the put decrease when the value and performance of an underlying asset or security increases, and vice versa.  
• On the other hand, call options have a positive relationship with the cost of the underlying security. In the event that the particular asset’s value rises, so will the call premium, but only if there are no progressions in different variables, for example, IV or Implied Volatility or time available until expiry. 
• In case, while trading in call options, if the value of the underlying security sharply drops then the call premium will decay too, only when all remaining things stay consistent. 
• A decent method to envision delta is to think about a racing track. The tires of the racing car address the delta, and the gas pedal addresses the basic cost of the asset or security. 
• Low delta options resemble race vehicles with economy tires. They won’t get a ton of grip when you quickly speed up. Then again, high delta options resemble racing tires. They give a great deal of speed when you hurry up. 
• Delta is usually utilized while deciding the probability of an option being ITM or In the money at agreement’s termination. For instance:
  • A call option in OTM or Out of the money having a 0.20 delta has about a 20% possibility of being ITM at expiration.
  • However, a call option in ITM with a 0.95 delta has a generally 95% possibility of being the same at contract termination.
• The hypothesis is that the costs will follow a distribution similar to a coin.
• On a significant level, this implies investors or traders in options trading can utilize delta to calculate the danger of a given option. Higher deltas might be appropriate for high-hazard, high-reward techniques with low win rates while lower deltas might be undeniably appropriate for low-risk techniques with high win rates. 

For sure, Delta is also utilized while deciding directional risk related to option trading and strategy. Positive deltas are long (purchase) market presumptions, negative deltas are short (sell) market suspicions, and impartial deltas are unbiased market suppositions. 

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Delta Examples

To make it more understanding, let’s have a look at the real-world example of Delta:  

Let us assume that a trading deal in-the-money (ITM) option has a delta of 0.80 while another option in the out-of-money or OTM option has a delta of 0.25. If the underlying asset or security rises with Rs. 1 then Rs. 0.80 rise will be seen in the first option and an Rs. 0.80 rise in the latter option. 

Traders or investors who search for the best traction might need to think about high deltas, albeit these options will in general be more costly as far as their expense factor is concerned since they’re probably going to delay ITM. 

The ATM option, which means the option’s strike cost and the underlying security’s cost are equivalent, has a delta estimation of roughly 50  or 0.5. That implies the option premium in the underlying asset will rise or fall significantly a point with a one-point go up or down. 

This options trading risk measuring factor changes as the options become more productive or become ITM (In the money) because of the option’s strike cost being greater for the cost of a stock or share. 

Basically, at delta estimations of – 1.00 and 1.00, the options act as the underlying asset regarding value changes. This conduct happens with next to zero time an incentive as the greater part of the estimation of the option is intrinsic. 

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Delta and Directional Risk   

At the point, while doing options trading when you purchase a call option, you need a positive delta since the cost will arise alongside the price of an underlying asset or security. 

In case you purchase a put option, you need a negative delta where the cost will fall down if the cost of the underlying asset increases. 

Following are the three things to remember with delta: 

• Delta will in general build nearer to contract termination for close or ATM options. 
• Additionally, Delta is assessed by gamma, which is a proportion of the delta’s pace of progress. 
• Further, Delta can change in response to IV or Implied Volatility transformation. 

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Gamma 

Gamma quantifies the pace of changes in delta over the long run. Since delta values are continually changing with the cost of the security or asset, gamma is utilized to quantify the pace of progress and furnish traders and brokers with a thought of what’s in store and what to expect later on. 

• Gamma calculations are most noteworthy for options such as ATM (At The Money) and least for those choosing out-of-the-money or OTM.
• While, with the changes in the security or asset, delta changes. On the contrary, gamma is a constant that addresses the rate of progress of delta.
• This makes gamma helpful for deciding the reliability and firmness of delta, which can be utilized to decide the probability of an option arriving at the strike cost at the date of termination. 
• The high gamma range implies that the options will in general experience unpredictable swings, which is something worst for most traders and investors who search for predictable changes. 
• A decent method to consider gamma is the proportion of the stability or firmness of the probability of an option. In case, the delta represents the likelihood of being ITM  at termination, gamma addresses the fitness of that likelihood over time. 
• For instance, assume that two options have a similar delta range, yet one option has a high gamma, and the other has a low gamma. The option with the higher gamma will have a higher chance of risk since a small move in the value of the stock or share price will have a larger than average effect. 
• An option with a high gamma and a 0.75 delta may have a lesser degree of possibility of terminating ITM than a low gamma option with a similar delta. 

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Gamma Example

Let’s make the understanding of gamma more simple with the support of an example. 

Refer the below table with gamma values of an underlying stock or asset-

 

The above table shows how much delta changes, following a one-point move in the cost of the asset.

At the point when call options are profound OTM, they have a little delta since changes in the asset produce small changes in values, for the most part.

The value of the delta in the stock is ascending from left to right (1993, 1994, 1995,…….,2002)  and it appears with values for gamma at various levels of the asset.

The segment demonstrating profits along with losses (P/L) of -200 addresses the AM strike of 1998, and every section addresses a one-point change in the asset. 

ATM gamma is -0.79, which implies that for each one-point move of the asset, delta will rise by precisely 0.79.

If you move right to the following segment, which addresses a one-point move higher to 1999 from 1998, you can see that delta is -53.13, an expansion of 0.79 from -52.34.

Delta rises as this short call option moves and the negative sign implies that the position is losing in light of the fact that it is a short position.

Thus, it means that the position delta is negative. Therefore, with a negative delta of -51.34, the position will lose 0.51 range in premium with the following one-point ascend in the asset. 

Therefore, while using Gamma as the risk measuring tool, you must give an extra focus to the below points:

• Gamma is the littlest for deep OTM and somewhere deep ITM options.
• Gamma is most elevated when the option gets close to the cash. 
• Further, for the long options position it’s positive and for the short positions in option trading its negative.

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Theta

Theta quantifies the pace of time declined in the cost of an option and its premium. Time declined addresses the spoils of an option’s cost because of the passing of time. 

• Over the long haul, the possibility of getting profits from options of ITM decreases. 
• Time-delayed will, in general, accelerate as the termination date of an option contract moves nearer since there’s less time left to make a profit from the trade. 
• Theta is consistently negative for a particular option since time moves in a similar way. When an option contract is bought by an investor or trader, the clock begins ticking, and the price of the option quickly starts to decrease until the day of its expiry, useless, at the predefined termination date. 
• Theta is useful for option writers. However, it’s terrible for purchasers. A decent method to picture it is to conceptualize an hourglass where one side is the purchaser, and the other is the writer. The purchaser should examine when or whether to practice the option as quickly as possible. 
• However, meanwhile, the price and value is moving from the purchaser’s side to the seller’s side of the hourglass. The development may not be very quick, yet it’s a nonstop loss of significant value for the purchaser. 
• Theta ranges are consistently negative for long options. Not just this, since time moves in a single way, they will consistently make some zero time esteem and time runs out when an option terminates. 

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Theta Example

Let’s quickly examine the theta concept with a simple example. 

An option contract premium that has no natural worth will decrease at a rising rate as the date of the agreement’s termination approaches. 

The below table shows theta range at various time spans for a NIFTY 50 January ATM call option. The strike cost is 930. 

 

As should be obvious, theta rises as the date of termination of options contract draw nearer (T+25 is termination).

At T+19 or six days before the lapse, theta has arrived at 93.3, which for this situation reveals to us that the option is currently losing Rs. 93.30 every day, up from Rs. 45.40 every day at T+0 when the trader or investor opened the option position. 

Theta value seems smooth and straight over the long haul, however, the slants become a lot more extreme for ATM options as the lapse date becomes close.

The time estimation of ITM and OTM options is extremely low close to termination. This happens due to the probability of the value arriving at the strike cost is low. 

Since there is little possibility of earning benefits or profits since the termination of the agreement is quite close. 

Options such as ATM ones might be able to arrive at these costs and acquire a benefit, however on the off chance that they don’t, the extrinsic worth should be limited over a brief period. 

Now, let us talk about some highlights about theta to consider when doing option trading: 

• Theta can be high for OTM options in the event that they convey a great deal of suggested instability. 
• Theta is commonly most elevated for ATM options since less time is expected to acquire a benefit with a value move in the asset such as stock, share, or commodity. 
• Theta will rise dramatically as time-delayed quickens over the most recent couple of weeks before the contract termination date. It can seriously run a long position that an investor or trader holds in options trading, particularly when IV declines simultaneously. 

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Vega

Vega quantifies the risk of changes in IV or the forward-looking expected fluctuation or unpredictability in the cost of the underlying security. 

• While delta estimates genuine value changes, vega is centered around changes in assumptions for future volatility. 
• Higher unpredictability makes options more costly since there’s a more noteworthy probability of hitting the strike cost sooner or later. 
• Vega reveals to us how much an option cost will rise or fall given an expansion or reduction in the degree of IV.
• Option writers profit by a fall in IV, however, option purchases profit when there is an increase in IV. 
• It’s essential to remember that IV reflects cost activity in the options market and it increases as the option cost is bid up due to high volume of purchasers in the market.
• Long option investors profit by costing being offered up, and short option traders and investors profit by costs being offered down. 
• Long Options = positive (+) vega
• Short Options = negative (-) vega

Some of the points that need extra focus in respect to vega: 

• The value of Vega can rise or decline without the change in the underlying asset or security cost simply because of changes in IV. 
• In addition to this, Vega can increase in response to sudden moves in the particular security. 
• The value in the Vega falls as the option draws nearer to its termination date.

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Options Trading Risk Calculator

Although there are two different ways to calculate option trading risk namely- conventional and alternative. But, we believe that the conventional is more popular and easy to use. So, let us understand the same with the help of options trading examples. 

Let’s begin, shall we? 

Option Trading Risk Calculator- Conventional Way:

• This is one of the highly used ways in the stock market that most of the option traders frequently use while balancing risk difference or disparity. 

Let’s see how does conventional way work with the help an example-

If an option trader plans to buy 200 shares of a company at RS. 50 each share, then the investment that he needs to do will be Rs. 10,000. However, he can also purchase these 200 shares, by buying two different call options agreements or contracts. 

Surely, it will be wiser to buy two contracts since these contracts are cheaper than buying the same amount or volume of shares. Hence, you can save the money that could be used to buy 200 shares. 

In simpler words, the amount of option contracts is particularly based on the number of shares that could have been purchased with the financial investment.

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Let’s assume that an investor named Jatin Thukral plans to purchase 1000 shares of a hypothetical company name ABC India. The price of these shares is Rs. 41,750 costing one share at a price of Rs. 41.75 paisa. 

Now, he has one more choice i.e. instead of buying these shares at Rs. 41.75 paisa, he can purchase 10 call options with a fixed price or strike price at the value of Rs. 30 (ITM or In the Money option). Hence, the total payment will be Rs. 1630 per contract. 

To buy these 10 call option contracts, the total amount that he will be required to spend is Rs. 16300. Hence, he has made a considerable profit by saving a total value of Rs. 25,450; which is about 60% of the amount that he will be required to pay while purchasing the shares.

Jatin Thukral can use this saved amount in a plethora of ways such as –

• He can diversify his portfolio by spending this amount on other investment classes or segments. 
• He can also keep this amount in the trading account to earn money market rates with high-interest rates. 

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Option Trading Risk Management 

Now, let’s understand how to minimize the risks associated with Option Trading.

Option Trading can be quite risky and complex trading segment however it can be highly profitable too with attractive returns.

All you require is an effective strategy to manage these risks and you can also follow some of the methods and advices shared as below-

1. As an options trader or an investor, the initial phase in managing risk is position sizing. When he purchases such kind of contracts the amount of capital he spends on purchasing an options agreement is the most he can lose if his option contract expires useless before the termination date.

2. When trading in the options segment, the most ideal approach to stay away from the potential risk of loss is to never put on a position size of more than 1% to 2% of your complete trading deal. 

Let us suppose that you have a total amount of Rs. 50,000 in your trading account of options, then in such case your maximum option position size must be Rs. 500.

3. If you plan to sell an option contract to open your risk can be hypothetically limitless except if you purchase a further away option contract as a hedge. Utilizing fix loss options contracts plays is significant so you cap the measure of your losses if a solid pattern moves against your short option. 

Additionally, you should purchase your hedge at the cost which is most favorable to you in covering losses or risks. 

4. On the off chance that you sell a covered call, then your risk is in the stock or underlying asset. You can set a stop loss for your stock position where you can minimize your losses and purchase to cover your short call. 

5. On the other hand, if you decide to sell a married put, then your risk comes in the short stock. Again, you can set a stop loss for your short stock position where you will minimize your losses and purchase to cover your short stock and purchase to close your short put option. 

6. Finally, try not to put on options as it’s an open risk or unclear danger play. It is hazardous to open yourself to uncapped and limitless risk selling options contracts, the chances are that at last you will be destroyed on one outsized move. 

7. Always know when to sell call options and make sure to have an exit technique when you sell options contracts and don’t forget that hedges play a significant role when it comes to protection against losses. 

Albeit each trading and investment segment has certain risks associated with it, make sure to have an efficient strategy to minimize losses. Also, before trading in options have a piece of brief information and understanding about this segment. 

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Closing Thoughts

If you are into the investment world, then you must be aware that no trading or investment field is a bed of roses. There are a plethora of risks that you have to take in order to earn quite well and make profits. 

Similarly, in options trading, the risks are few however they must be carefully taken care of by the investor.

Before making the choice of entering the stock market, it is vital to have an understanding as well as knowledge of the options concepts, terms, features, strategies, etc. 

Some of the risks associated with options trading are higher financial loss during the trading, a bit complex way of trading and investing, requires better strategies, higher liquidity, prompt upfront payment, and most importantly time- it is a big hindrance for the short-term investors. 

If you also wish to go ahead with the options trading, then make sure that you have important information about the risks or dangers associated with options trading. 

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Wish to get into a trade, get started by opening a demat account. Fill the form below and a call back will be arranged for you in no time.

 

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