Options offer traders some unique advantages and are undoubtedly a great way to enhance your portfolio. They can also help mitigate losses in the stock market. When traded correctly, options can help a trader have defined risk, but it’s important to remember that options are not risk-free trading tools. 

Understanding the risks associated with options is key to your trading — as well as getting clearance from your broker to trade more advanced options strategies.

Let’s take a closer look.

Risks When Trading Options

There are some major risks associated with trading options, and in order to be a successful trader, you should familiarize yourself with these and monitor these potential hurdles very closely.

Some risks to options traders include:

• Time 
• Volatility
• Substantial risk of losses on short options

Time Decay

The most important thing to understand is that every option will expire. As such, there’s a time value factored into each option’s premium. 

Unlike stock investing, time is not your friend as an options buyer… and the closer you get to expiration, the faster the premium in the options will erode due to time decay.

In other words, if you don’t get a strong move by the stock in the right direction by the time the option expires, you’re liable to lose money on the trade… even if you’re kind of right on direction. 

Some things you can do to help combat time decay are:

• Buy options that are at the money or in the money to minimize the impact of time decay.
• Trade options with expiration dates that are more than one month out. Three months is generally considered a “sweet spot” for short-term traders, since it allows more time for the trade to play out. However, it’s important to note that premium may be higher the further out you go.
• Don’t hold your option through expiration, since that is when the fastest rate of time decay will occur.

Volatility

Volatility occurs when stocks go up or down, and is another factor in determining an option’s price.

It is integral that option buyers are aware of implied volatility (IV), which measures the market’s expectation of price movement in the next year. 

Implied volatility will increase or decrease depending on supply and demand, and a higher IV means higher option prices, while a lower IV translates into lower option prices. 

When you buy options, you want IV to be as low as possible, so you can profit on any increases in IV. If implied volatility is elevated, it means you’ll be paying more premium to initiate your position — which limits the benefit of leverage. 

Traders should be aware that IV tends to rise into expected events like earnings or FDA announcements, since these catalysts tend to spark bigger share price moves.

The risks outlined above are for option buyers. Options sellers, on the other hand, are in a position to take advantage of time decay and elevated IV levels. We’ll take a deeper dive into options selling in a later section, but it’s important to underscore this potential risk to call and put writers.

One Major Risk to Option Sellers

The most notable risk to options sellers is the potential to suffer significant losses — which is why naked call and put selling is only a strategy allowed to options traders who have margin accounts and have reached the top level of clearance from their brokers. 

Being “naked” when you are short options means that you are selling a call or a put without a proper hedge against it.

While options buyers’ risk is limited to the premium paid, sold calls carry the potential for theoretically unlimited losses and sold puts could lead to substantial losses.

Why?

Because when you sell an option, you are obligated to deliver the stock at the strike price if the option is assigned. This creates substantial risk to sellers, since, for call writers, there’s theoretically no cap on how high a stock can climb, and for put writers, their losses will accumulate on a move all the way down to zero.

Wrapping Up

Options are flexible tools and hold the promise of massive returns to traders, while also minimizing losses when used properly. However, options are not risk-free, and it’s important to do your research on the risks associated with trading these derivatives. 

For options buyers, factors that impact a contract’s price like time decay and implied volatility could potentially eat into profits, while option sellers must understand that they open themselves up to substantial losses if their contracts are naked, or uncovered.

It’s also important to know what your personal risk profile is before pulling the trigger on a trade. If you’re a beginner, start small and get a feel for how option’s pricing works and what risks are out there.

All options lose value as time passes, like a produce item at your local grocery store.

In options, this is known as time decay, and is measured by the Greek “theta.”

Theta is one of the four primary greeks that traders use to describe and analyze various risks to an options trade at any specific point in time. Theta is measured as a value in dollars, and tells us how much an option premium loses (or gains) each day through expiration.

Theta, or time decay, is not linear. Theoretically, the rate of decay will accelerate for the option as expiration approaches.

At first, the rate of decay measured by theta is negligible the further out the expiration period goes, and rapidly accelerates as expiration nears.

Here is a chart illustrating this more clearly.

As you can see from the image above, time value of an option decays at a quicker pace as you approach expiration. At expiration, an in-the-money option has no time value, only intrinsic value.

Long calls and puts have a negative theta, while short calls and puts have a positive theta. In other words, time decay works against the option buyer, but works in favor of the option seller.

Why?

Because the more value an option loses over time, the less expensive it is for the option seller to buy back the contract.

Theta and Implied Volatility

Theta and implied volatility go hand in hand. You see, implied volatility affects the extrinsic value in options, which affects theta values. Generally speaking, the higher the implied volatility, the higher the theta.

There are many influences on an option’s implied volatility that can in turn impact theta. These include upcoming earnings announcements, product releases, drug trials, tariffs, etc.

Here is a chart that describes the relationship of implied volatility to theta.

Theta and Moneyness

At-the-money options are most susceptible to time decay, while theta will decrease the deeper in the money or out of the money an option moves.

For traders who are long options, it is a good idea to try and avoid the impacts of time decay by picking an option that has an expiration date that’s further out. A good rule of thumb is to target an option with 60-90 days until expiration to avoid a rapid decline in your option prices each day, though these further-dated options will likely be more expensive because of the additional time value that’s priced in.

For traders who are short options, it is a good idea to try and target shorter-term contracts that have the greatest acceleration of time decay. These can typically be found in options that have between 0 and 60 days until expiration.

Some additional points about theta to consider when trading:
1. Theta can be high for out-of-the-money options if they carry a lot of implied volatility.
2. Theta is typically highest for at-the-money options since there is a greater chance they will finish in the money.
3. Theta will increase sharply as expiration approaches, and can severely undermine a long option holder’s position, especially if implied volatility declines at the same time.
Wrapping Up

Understanding theta is extremely important when trading options, since it lets you know how much the price of an option should change as expiration approaches. As an option buyer, your position has a negative theta — which works against you as expiration nears. On the other hand, when you sell premium, your position has a positive theta, which works in your favor. Being aware of this greek is another way to choose the options trade that works best for your risk profile.

Vega is the greek that represents an option’s sensitivity to implied volatility.  

More specifically, vega measures the change in an option’s price for every one percentage point change in implied volatility. So if an option’s vega is 0.10 and its implied volatility rises 1%, the option’s price will increase $0.10. On the other hand, if implied volatility falls 1%, the option’s price will decrease $0.10.

Vega is positive for both calls and puts, and is most sensitive when an option is at the money.

As a quick refresher, implied volatility (IV) is a forward-looking value that represents the market’s best guess on future price movement in an underlying asset. 

While everything else that goes into an option’s price is known: interest rates, dividends, time to expiration, and stock price, implied volatility is unknown. However, you can solve for implied volatility using the current price of an option.

Unlike delta, which measures how an option’s price will change based on an actual price change in the underlying stock, vega estimates how much an option will gain or lose based on an increase or decrease in the option’s implied volatility. 

When the market expects higher volatility from a stock — perhaps ahead of earnings, which can trigger big moves on the charts, an option’s IV, which is expressed as a percentage, will be higher. On the flip side, if the stock is expected to stagnate during the option’s lifetime, its IV will be lower.

The other things that factor into IV are the time until expiration and the stock’s price.

The more time an option has for the stock to make a big move, the higher that contract’s IV. Therefore, shorter-dated options are less susceptible to IV changes.

The prices of out-of-the-money and at-the-money options feel fluctuations in IV the hardest, because they’re made up of only extrinsic value. The price of in-the-money options don’t fluctuate as much with IV changes, as their premiums are largely made up of intrinsic value.

When a trader is long an option, they are said to be long vega, and will therefore benefit from an uptick in volatility.  And when a trader is short an option, they are said to be short vega, and will therefore benefit from a decrease in volatility.

It’s important to not confuse implied volatility with historical volatility, which measures how much the asset has actually moved in the past. However, implied volatility is often compared to a stock’s historical volatility to determine if an option’s price is expensive or cheap, relatively speaking.  

Additional points to keep in mind with regard to vega:

• Vega can increase or decrease without the price of the underlying asset changing, due to changes in implied volatility.
• Vega can increase in reaction to quick moves in the underlying asset.
• Vega falls as the option gets closer to expiration.

Wrapping Up

Implied volatility is a major factor determining an option’s price. When you buy an option, you want implied volatility to increase, so you can sell the option at a higher price than you initially paid. 

On the flip side, when you sell options, you want implied volatility to decrease, so that you can buy the option back at a lower cost.

These changes in implied volatility — and how it impacts an option’s price — are measured by “vega,” which is just one of the “Greeks” options traders should understand before pulling the trigger on a trade.