Options trading allows you to buy or sell stocks at a preset price and within a preset time frame. You can see some good gains from trading options without spending a lot of money upfront since you’re not buying the stock outright until you exercise the option. If the price reaches an amount that fits your needs, you can buy the option. However, if the stock doesn’t hit the price you were hoping for, you can let the option expire. Though trading options poses less of a risk than trading actual stock, there are some pitfalls to be aware of.
1. Potential Losses
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Options trading can be a high-risk, high-reward strategy. When you buy or sell options, you’re hoping the stock will rise or fall to just the right point for you to exercise your option and make a profit. If it doesn’t hit the range you expected, your options could expire worthlessly, meaning you would have spent a lot of money with nothing to show for it.
For example, if you bought $3,000 in call option premiums and the stock rises, you can exercise your option to buy and realize the profits. However, if you bought $3,000 in call option premiums and the stock falls, you could lose all $3,000 when the options contract expires. Had you invested $3,000 directly into stocks, you would only lose money if the company’s share prices take a hit.
2. Liquidity of Options
Market makers are typically used by exchanges to ensure there are reasonable amounts of liquidity available. However, this doesn’t remove the risk of low liquidity. Low liquidity may impact how many shares you can sell at once. If you’re dealing in large numbers but the liquidity is fixed below what you are trading, you may not be able to move your shares quickly enough to realize a profit.
3. Complexities of Options Trading
The market uses option Greeks, like delta and gamma, to measure an option’s sensitivity to change. Delta calculates how the option’s price changes in relation to the stock’s price. Gamma assesses how sensitive an option’s price is to delta.
Gamma reflects the option’s delta rate of change for every one-point move in the stock price. This is important because gamma options change depending on how close the option strike price is to the stock price. For example, if an option has a delta of $0.50 with a $0.02 gamma, then for every $1 change in the underlying stock, the option delta will change by $0.52.
4. Time Decay
Any options you buy have a time value and are subject to time decay. Options start with a high time value, and that value slowly decreases the closer you get to the expiration date. If you wait too long to exercise your option, you could end up with a smaller profit than you had hoped.
There are many more options trading risk factors to consider. Doing your research before you begin is important. Equally so is staying on top of the market every day to be sure you’re making good decisions.