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Thursday, April 6, 2023

Are Options Risky to Trade? Yes and No

As with most things in life, the risk associated with options largely comes down to how you approach them.

Image Credit: TheInvestorPost - Pixabay

If you’ve ever dabbled in the stock market, you may have heard about options. Options are a special kind of financial instrument that are a little more complicated than stocks, but also offer more flexibility for investors.

One of the first things young investors are often told about options is that they are risky and should generally be avoided. And if you’re still working out the difference between Bid and Ask, that’s good advice. Since options add a layer of complexity on top of stocks, you need to make sure you understand stock trading first before you venture into this market.

Having said that, it seems this well-meaning advice has created a certain mythos around options, that they are an inherently dangerous product that only a fool would go near. Many people seem to have the impression that options trading is risky as such, and that the options market is little more than a game for speculators, in the same category as cryptocurrency and lottery tickets.

In reality, this is quite far from the truth. Though options can be risky—especially if you don’t know what you’re doing—they don’t have to be. In fact, options can even be used to mitigate risk. To understand how, let’s take a quick look at how options work.

Options: A Brief Primer

The simplest way to understand options is that they are a contract where one party pays a premium and the other party makes a promise. Insurance contracts are a good analogy. The buyer pays a certain sum of money (the premium), and in exchange the company agrees to cover certain losses over an agreed-upon time frame (the promise).

The main difference with an option contract is the nature of the promise. Instead of buying the right to have certain losses covered, the buyer purchases the “option” of buying (or selling) a certain stock at a specific price within a certain time frame. If they purchase the option to buy it’s called a call option. If they purchase the option to sell it’s called a put option.

Let’s walk through an example of each to see how this works. Say stock ABC is currently trading at $100, but I think it’s going to rally to $200 in the next year. If I want to bet on this happening, I could simply buy the stock. But another way to bet on this is to buy a call option.

One option I could purchase is the option to buy this stock at $120 at any point in the next year. I would then pay a premium for that contract, say $30, and the person receiving the premium would make the promise to sell me that stock at $120 whenever I “call” them and ask for the trade. If the stock goes up to $200 before the year is up, as expected, then I can exercise the option. The promise-maker would be legally bound to sell me the stock at $120, and then I can either keep the stock or turn around and sell it in the market for $200, making a nice $80 gain (not bad for a $30 investment).

Further, since that $80 gain is on the table for whoever holds the contract, that contract will fetch a good premium in the market (much higher than the $30 I paid for it), so if I wanted I could sell the option contract in the option market (before the year is up) for whatever the going rate is, and make my gain that way.

If the stock doesn’t get above $120 in that year, of course, then I’m simply out of luck. I’ve lost $30, and that’s the risk I took.

With call options, it’s easy to see how options can be risky. You stand to lose your entire premium if the market doesn’t go your way. Then again, you also open yourself up to a big windfall if things do go your way. Risk and reward go together, after all.

But just as options can be used to take on risk, they can also be used to mitigate risk, and the put option offers a good example of how this can work.

Let’s say I own stock XYZ—currently trading at $100—and I’m worried about a market crash. I want to keep holding my stock, but I don’t want to risk losing $40 if the price drops to $60. To mitigate this risk, I can buy a put option, which is the option to sell at a certain price within a certain time frame. For instance, I might pay a $5 premium for the right to sell at $90 over the next year. With that contract in hand, I don’t have to worry about a market crash. If the price goes to $60, I can simply exercise my option and sell the shares at $90. Sure, I’ve still lost $10, but I would have lost $40 if I didn’t have that option.

In a sense, put options are the insurance sector of the stock market. They allow you to pay a small premium upfront to effectively insure against a market crash. The way they do that is by guaranteeing that you’ll be able to sell at an agreed-upon price, even if the market price goes far lower.

With the above two examples, it may seem as though call options are the risk-on alternative while put options are risk-off, but in reality it’s not quite that simple. For one, you can always flip the risk by taking the other side of the trade—that is, being the one selling the option instead of buying it. There are also more advanced strategies involving multiple options (vertical spreads etc.) which allow you to basically craft your own custom risk profile, taking risks in one place to open up the possibility for reward somewhere else. The possibilities are truly endless.

A Better Approach to Risk

As you can see, options are not inherently risky or safe. It’s all about how you use them. Options can be used to take on risk, but they can also be a great tool for mitigating risk, one we avoid to our detriment.

The point is, we need to move away from this binary thinking that says things are either risky or safe. The truth is it’s always a difference in degree, and the risk something carries often depends on how you approach it. And this doesn’t just apply to options. It applies to every area of our lives.

One of the downsides of binary thinking about risk is that when we’re told something is “risky” we tend to shy away from it. But this is an unbalanced approach. Yes, options carry risks. So does entrepreneurship. So does asking someone out. But if you never expose yourself to those risks, you’ll never be able to reap the rewards those risks make possible.

Our approach to finances—and life in general—should not be about avoiding things people say are risky. Rather, we should strive to develop competence so we can manage risk effectively. If you don’t know what you’re doing with options, they can be incredibly risky. But that doesn’t mean you should never touch options. It means you should develop knowledge, skill, and mastery so you become the kind of person who does know what they’re doing.

The best way to approach life is not to avoid risk, but to competently seek out the right balance of risk and reward—even if that sometimes means stepping out of your comfort zone.

This article was adapted from an issue of the FEE Daily email newsletter. Click here to sign up and get free-market news and analysis like this in your inbox every weekday.

  • Patrick Carroll is the Managing Editor at the Foundation for Economic Education.