The main risks of options

Options are used to take risk and to reduce it, and the same contract does one or the other depending on what else its owner holds. The risks below are the ones that belong to the contract itself. Each strategy page of this library states its own maximum loss.

The risk of losing the whole premium

The buyer of a call or a put can lose everything paid for it. This is not a rare outcome. An option that is out of the money at its expiration is worth nothing, however close the stock came to the strike price.

A loss of 100% needs no large move of the stock. A call bought at the money for $1.80 is a total loss if the stock stands at the same price on the expiration date. Shares bought on the same day would have lost nothing.

The risk of writing an uncovered call

The writer of a call must deliver 100 shares at the strike price when the call is assigned. A writer who does not own the shares has written an uncovered option and must buy them at the market price. That price has no upper limit, and so the loss has none.

A call written at a strike of $55 for $1.00 loses $900 per contract with the stock at $65, $4,400 with the stock at $100 and $14,400 with the stock at $200. The premium received was $100.

The risk of writing a put

The writer of a put must buy 100 shares at the strike price when the put is assigned. The loss is the strike price less the price of the shares, less the premium received. It is largest when the stock falls to zero: the strike price less the premium, per share.

A cash-secured put has the same loss as an uncovered one. The cash changes who is able to pay for the shares, not what the shares are worth afterwards.

The risk that comes with leverage

An option costs a fraction of the price of 100 shares and moves with them. Leverage is the result: a move of a few percent in the stock is a move of tens of percent in the option.

Leverage also lets a position grow larger than its owner intended. The premium is small, so many contracts can be bought or written with little money, and the obligations of written contracts add up.

The risk of time

An option has an end. The part of a premium that pays for time is lost by the expiration date in every case, which is called time decay. A holder can be right about the stock and lose money because the move came after the expiration date, or was smaller than the premium.

The risk of assignment for a writer

Options on stocks can be exercised on any business day. A writer can be assigned before the expiration date, an early assignment, and learns of it only after the trading day has ended. The risk is highest on the day before the stock goes ex-dividend: the writer of a call who is assigned then delivers the shares and does not receive the dividend. A writer of a put who is assigned has to pay for the shares.

Brokers hold collateral, called margin, against written options. When the stock moves against the position the broker can ask for more, and can close the position at the market price if it is not provided.

The risk of a market that is hard to trade in

Not every option is easy to trade. Liquidity shows in the spread between the bid and the ask: when it is wide, every entry and every exit costs a visible part of the premium. When trading in a stock is halted, trading in its options is halted too. A position cannot be closed in the market during a halt, and the writer of a put who is assigned must buy the shares whether they trade or not.

What a broker requires before options can be traded

A broker must approve an account for options trading before the first order. Brokers generally offer several levels of approval, which stand for different degrees of risk, and decide which one an account receives. The broker also provides the Options Disclosure Document, the booklet "Characteristics and Risks of Standardized Options", at or before the time the account is approved. It describes these risks in detail.