Risk vs. Reward in Options Trading

Have you heard to stay away from options because they are way too risky? I know I had before starting to study option trading myself. Since then I’ve learned there are risky trades and there are very conservative trades. The following article gives good examples of both.

Trading options is risky and should not be traded by inexperienced traders. The main reason is because the risks are non-linear in nature and depends on a variety of factors beyond the value of the underlying security. Reducing the amount of risk you take on when trading options stem losses, but also stifles your ability to realize large gains. For example, take a look at covered calls versus naked calls.

A covered call is a call option where the seller owns enough of the stock to sell to the buyer in the event the buyer exercises his option to buy. The seller of the call can make money in this situation; however, by owning the underlying security, the profits realized on the option trade are reduced by the amount of money spent to initially acquire the securities. A naked call, however, means that an investor sells a call without owning enough (or any) of the underlying security to sell to the buyer in the event he or she exercises his option to do so. This means that the investor will have to purchase the underlying security at current market price and then sell it to the call holder, potentially at a huge loss.

The main benefit to writing a naked call is that the seller can realize  gains if the market moves favorably, since he can collect the premium on the call without ever having to outlay money for the security itself. However, this is an extremely risky move since market volatility can easily move against the investor.

However, trading options can be considerably less risky than trading stocks. When trading stocks, investors must lay out a considerable amount of cash to own the security and hope that the stock’s value moves upward in value. Every dollar the stock moves downward is a loss to the investment. With options, investors can take advantage of just about any market condition and risk much less cash to control the same number of shares. Options traders can even make money if the value of the stock remains stagnant, something a stock traders simply can’t do.

See IncomeTrading.com for more

Option Trading Secrets

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