Options trading is in some way similar to stock trading, but they’re quite different. They carry some risks that we need to talk about.
Before we dive in, I think it’s necessary to briefly define what options are:
An options contract offers the buyer the opportunity to buy or sell the underlying stock. Each standard option contract is equivalent to 100 shares of the underlying asset.
There are a number of benefits to trading options – especially the leverage they give compared to penny stocks.
But let’s take a look at the downsides/risks associated with options and why they can be difficult to trade.
1. Poor liquidity
Liquidity is a simple way to measure the number of sellers and buyers present, and the ease at which transactions can take place.
It plays a huge role in the market — and when it comes to options, the bid-offer spread is affected by the liquidity.
A key point to keep in mind is that the more liquid a stock or option is, the easier it is to trade.
Now, most stock options lack a lot of volume, which means spreads can be large.
Since stocks will have options trading at different strike prices and expirations, there’s a high chance that the specific option you are trading will have a low volume. The exception, in this case, will be some of the big-name popular stocks.
The large spread translates to less liquidity for those options.
This lower liquidity won’t matter much to a small trader that is trading just 10 contracts though.
2. A Race Against Time-Decay
Options trading is similar to trading stocks when looking at liquidity.
But one key difference between the two is that, unlike stocks, the prices of options decrease over time. That’s why the term “decaying” is used to describe them.
For anyone that isn’t familiar, Theta is used to measure time decay — which is the rate of decline in the value or price of an option due to the passage of time.
Something every options trader should keep in mind is that…
The closer a contract moves towards its expiration date, the more the time decay increases as. Simply put, the price of an option goes down every minute as it approaches expiration.
This can be frustrating for inexperienced traders as you may need to think quickly and adjust as things change.
Side Note: There are some strategies — like Put Credit Spread, Call Credit Spread, Naked Puts, and Short Iron Condor — that allow traders to take advantage of theta decay and collect premiums as time goes by. We’ll discuss that in more detail in a different article.
3. Uncertainty of Profit
Traders rely on risk profile graphs when executing options strategies.
These graphs show the range of profit or loss possibilities for a trade. On the horizontal side is the price of an underlying security at its expiration date, while the vertical axis shows potential profit or loss.
Before we move forward, here’s a quick refresher:
VIX measures implied volatility across different US stock indices.
When the VIX is low, it means there is less market fear, more stability, and long-term growth. On the flip side, the VIX going up signals market stress — it means that there are significant and rapid price fluctuations on the S&P 500.
The risk profile chart assumes that implied volatilities will stay the same.
This means that when the options expire, traders do not get the gains they expected…usually because option prices fall. It can get frustrating when the stock performs as expected, yet you still don’t make the gains you hoped for.
Don’t get me wrong, there are times when the VIX rises and traders gain even more than the risk profile graph had estimated.
Summary
A lot of traders love options as they require significantly less up-front capital.
But it’s not all bread and butter.
Like anything else, it has its upsides and downsides. As much as it is rewarding, options can also be risky…especially for beginners.
That’s why it’s important to be constantly learning and improving in order to boost your chances of success.
You need to focus on the process and learn. Invest in resources that will help you improve your risk management skills, fine-tune your plan, and overall make better decisions.
Always keep learning!
