PERILS WHEN INVESTING IN OPTIONS
Volatility from options can hugely hurt the option pricing and result in risks for investors. Liquidity plays a vital role for determining volatility. Most options can be traded without the impact of a wide bid-ask spread. Options with minimal liquidity can rise or fall since few trade it. Remember, the options are liquid when the underlying security is liquid, too.
Another indicator is the open interest, the total number of option contracts currently open. It refers to option contracts being traded but not yet settled by offsetting a trade or exercising the options. The variation in open interest can figure out whether the daily trading volume is high or low. The higher the open interest, the more profitable the option is.
Aside from the options itself, option writers face the following perils:
- Call option writers need to deliver the stock upon being assigned. An option may be assigned if the underlying stock’s price rises up to or higher than the call strike price. If the writer does not have the stock, the investor needs to purchase the shares in the open market. The difference in the stock’s price and the option’s strike price can be vast, and the loss can aggravate if the investor borrows stock to meet the contractual obligation. If the writer has the stock, the exchange will designate the shares to a holder.
- Put option writers have to deliver and pay for the underlying stock. An option may be delegated if the stock’s price falls down to or lower than the put strike price. When assigned, the writer will be forced to buy the stock at the option’s strike; he or she may end up paying more than the stock’s market price. Although the writer will receive a premium from writing the option, the premium can be significantly lower than the difference in the option’s strike price and the stock’s price.
- Covered call writers lose the right to the upside in the underlying stock. The writer receives the premium coming from the option, covered by possessing the underlying stock. But if the stock’s price declines, the writer is only shouldered by the option’s premium and will still sustain loss in the stock’s price.
- Short option positions are subject to margin calls. Margin requirements may change, prodding the investor’s broker to issue a margin call. So, an investor may be mandated to close all of the position and give additional money to fix the margin call.
- American style options can be assigned at any given time. Unlike European style options, which are only assigned on the expiration date, holders of American style option can exercise their options early, including when the stock goes ex-dividend or the option market is illiquid. In general, it is more profitable to sell the option than to exercise it. Early writers of options should become familiar about the possible situation before creating the option.
For option holders:
- Before exercising an option, he or she must be prepared to purchase the stock or deliver the stock. Call option holders who are in the money, which have not been closed out or fail to close out, must obtain the stock if options are exercised. For put option holders, the investor must deliver the stock if the funds are available to meet the contractual terms.
- Option holders may erase the entire premium paid for the option. They can avoid losing the remaining premium by winding up the long position before its maturity. They can also exercise the option. Or, if the investor uses options to neutralize an underlying security, the premium loss may be accepted.
- The closer an out-of-the-money option is to its maturity, the higher the chance the investor can close out or exercise with a profit. Time is the primary rival of out-of-the-money option holders since time value is their sole value, which drops as its expiration date draws near. Hence, the holder must be ready to lose the whole premium paid for the option.
Managing risk is all about learning the possible outcomes of a trade. But investors can use breakeven or payoff diagrams to understand more the potentiality of the trade. A payoff diagram displays the likely gains or losses of an option technique over a set of stock prices at maturity. Such graphs can be plotted for any option, or a combination of options.
Call options’ breakeven point is the exercise price plus premium. The writer’s potential profit is constricted to the premium received. For writers of uncovered call option, it will be more costly to purchase the shares at the market price if the option will be exercised, as stock prices rise above the strike price. While options are valued as a single item, the contract is equivalent to 100 shares. Hence, to obtain the price per option, multiply its price by 100.
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