First off, any trade, in fact almost anything that promises much profit surely carries with it lots of disadvantages. You only get what you pay for. As they say, you donít get free rides. When you give more then you would most likely get more. The same principle works with the trade. With higher promise of profit come higher and greater risks to be taken.
So what makes option trading a high risk venture? Itís definitely the leverage. Leverage, in trade speak, is one of those crucial things that could make or break your trade. It gives you the advantage while taking away your potential profit if you pick the wrong option or the wrong timing to trade. Leverage is so attractive that it is among the things that make people want to enter trading but it is also disadvantageous when not properly used. In the case of options trading, there is higher leverage offered. Depending on which side of the coin you look, leverage could either mean boon or doom.
As defined in its financial sense, leverage is a relatively small amount of money you invest in something that could turn out big. Sounds pretty interesting but whatís the problem? Just like what was mentioned earlier, a higher leverage could mean higher loss of profits if the trade is mishandled.
Apart from these, risks of options trading can be seen from two different perspectivesóthe buyerís risks, the sellerís risks.
Options trading offer the possibility of losing your entire investment in a relatively short period of time. It is noteworthy that the main essence of options trading is to control a certain asset within a certain period of time at a fraction of the assetís original price. So if you bought an asset that has an expiration of 3 months and within those months the stock remains at a certain price lower than what is profitable, then you could really lose all your investments very fast. Losses compound as the expiration date approaches.
This is the main reason why traders who are interested in this type of trading are advised to participate only with their risk capital.
Further, European style option, a classification of options trading, restricts its traders to exercising the option after the expiration date since it does not offer secondary markets. Also, there are certain option contracts that may further create risks as well as regulatory agencies that could limit the possibility of realizing the value of a certain option.
Option trading is also risky for the sellers. There are types of options that may have unlimited possibility of losses depending on the movement of the underlying stock. There are also occasions when even if there are no trading markets, sellers are obligated to sell options.
All the risks involved in options trading should be understood as something inherent to it. But any trader should not take the risks as the hook, line and sinker of the trade. As we have mentioned earlier, more risks mean better profits. So you should put into your calculation the risks but you must not forget the profit you could get from option trading.
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