Whenever I happen to tell someone that I trade options, I almost always get the question, “Aren’t options risky?” Well, the answer is- it depends! There are ways to use options that are very risky, and other ways that actually reduce risk. The longer I trade options, the more time I have spent working to understand and manage risk. Risk management starts with a plan for each trade, and managing the composition of an overall portfolio to control overall risk. In this post, I’ll do a brief overview of risk- levels of risk, risk considerations when opening a trade, managing a trade, and managing the overall risk of a portfolio.
Permission Levels of Risk
At most brokerages, traders have to request permission to trade options and request what risk level they want to be permitted to trade. Most brokers have four permission levels, and the levels line up with risk. When I first started trading, I really didn’t grasp how use of options in different ways led to different risk.
One way to think about risk is to consider how the notional value of the options impacts a trading position. The notional value is the amount that the strike price represents in total stock value. For example, one contract with a $1oo strike price option controls a notional value of $10,000 in stock. Each level of option risk leverages the notional value of the options differently.
Another consideration is the issue of assignment. Option sellers have the risk of positions being assigned to them, and buyers may choose to exercise an option. These choices and risks impact the way capital is allocated in an account.
So, let’s go through the different risk levels and see how they differ. I’m using levels zero to three, which is common, but some brokers have other numbering schemes, or may sub-divide some levels. The concept is what is important, not the level number.
Level 0- Covered Options
The least risky level of option trading is when options are secured or covered by either stock or cash. In these kinds of strategies, the risk of the option is countered by holding 100% of the notional value, requiring the underlying stock or security to move huge amounts for there to be a significant loss. For the most part, covered options strategies have less risk than owning stock outright.
The most common example of this risk level is the covered call. This strategy involves owning 100 shares of stock and selling a call option. As a call seller, a trader gives the call buyer the option to buy the 100 shares from them at a set price in exchange for a premium. If the stock goes down, the option expires worthless and the call seller keeps the premium from the option sale.From a risk standpoint, the worst situation with the option is that the underlying stock goes way up in value and the stock is “called” away, usually for a profit. The downside of this scenario is that the upside potential of the stock is capped. For the broker, there is no risk to allowing a trader to sell covered calls- either the call will become worthless, or the loss of the option increasing premium will be covered by equal gains in the stock paired with the option.
A similar covered strategy is selling cash secured puts. In this scenario, the broker allows the trader to sell a put, but reserves the exercise value of the put in cash in the trader’s account. So, if a put with a $100 strike price is sold, the broker would reserve $10,000 in cash to use in the event that the option is exercised and the buyer is forced to buy 100 shares for $100 each. Or if the price of the underlying security goes up and expires above the strike price, the option will expire worthless. In either case, the broker knows that the option sale will not stress your account.
There are a number of variations and combinations of these strategies that also share this level of risk. Generally, this level of risk involves taking the risk of stock and paying the stock owner or potential stock owner a premium to give up some upside. With covered options, the full notional value is covered or secured by cash or stock, so moves in price of the overall position match the notional value.
Assignment is a risk with covered options, but not really because the account has that risk covered by either stock or cash. If a call option is exercised, the trader has their stock shares purchased at the strike price- the shares simply turn into cash. If a put is exercised, the cash that was reserved is used to buy the shares at the strike price of the option- the cash turns into shares. This is the whole point of the option being covered.
One watch out in covered options is that the downside of a drop in stock price is not protected and is still a risk. This risk is the same as simply owning stock. For example, if a trader owns 100 shares of stock trading at $100, and the stock drops to $60 a share, it is a $4000 loss. If the trader sold a $100 strike call contract for $5.00/share or $500 for the contract, when the stock drops to $60, the shares still lose $4000, but the $500 premium collected effectively reduces the loss to $3500. It’s still a big loss, but not from the option, so the option isn’t risky, the stock is.
Covered options generally don’t make big returns or big losses but should do slightly better than just owning stock. The overall combination of stock and options have the potential for market losses and limited gains.
Because covered options have similar risk to simply owning stock, many people trade these strategies as a way to gain a little extra return with a little less risk compared to their stock holdings. Consistently selling covered options will actually reduce overall volatility, adding some income while limiting outsized gains and reducing losses. Because of this reduction in position volatility, covered options actually reduce levels of risk in a portfolio.
Level 1 – Buying Options
When a trader buys a call or a put, it is something like placing a bet. If I sell a call, I’m betting that the price will end up above the strike price of the call and will have more value than what was paid for. If I’m wrong, I lose all of what I paid and nothing more.
Buying options allows a trader to use a lot of leverage. For a fraction of the cost of 100 shares of stock, a trader can get the movement of the full notional value of the stock, but not the full loss if price moves against the position. However, the individual option can lose a much higher percentage than the underlying security. For example, if a trader buys a call for $5.00 on a $100 strike when the underlying price is $100, the trader could easily lose 100% of the trade value when the underlying moves only a small percentage. If a trader wagers a large portion of their portfolio buying options, losses could easily be 100% of the premium paid and cause a loss of much of the portfolio. The only good news is that the maximum loss is the amount paid for the option, and no more.
On the other hand, a winning trade could net several times as much as what was paid. Perhaps a stock goes up 10%, and the options gain 200%. The greater the move in favor of the trade, the greater the gain. Theoretically, profits have no upper limit.
There really is no assignment risk when buying options. As an option buyer, a trader has the option to choose when and whether to exercise an option. A winning option can be exercised, or it can be sold for cash. The choice is up to the trader who bought the option.
Buying options are very appealing to many people due to the unlimited upside. What many new traders don’t account for is the real possibility of the option being a total loss, and the relatively low probability of getting really big wins. But generally, the risk is pretty clear when opening the trade, compared to higher levels of option risk. For the most part, the trade wins big or loses big.
Level 2- Option Spreads
Option spreads are a combination of buying an option and selling an option on the same underlying, usually at different strike prices but at the same expiration. Spreads can be bought, a debit spread, when the option being bought is more expensive than the option being sold, or a spread can be sold, a credit spread, when the option being sold is more expensive than the option being bought. Spreads allow a trader to hedge a option, often to lower the cost of a position, or limit the risk. These hedges complicate the risk in ways that aren’t always obvious.
Most of my favorite trading strategies are some form of option spread. I like to sell put credit spreads, due to their high probability of success. However, spreads can leverage a lot of notional value and reach a 100% loss with relatively small moves in the underlying security. With credit spreads, I often collect 10% of the width of the spread, leaving 90% of the width at risk. If the market moves against me, I can lose nine times as much as what I collected.
Assignment is also a risk. The option I sold can be exercised by the buyer at any time. This usually only happens when a position is in the money, and when it does, it usually is at the worst possible time when cash is short. Brokers make traders have a margin capability to do these trades, so that if a position is assigned, it can be bought or sold even if there isn’t sufficient cash in the account. I’ve woken up to messages from my broker that a position was assigned overnight, and that I have a negative cash balance in my account. To solve this, I need to sell the assigned shares and close the other half of the spread, or the broker will start selling positions until my cash balance is positive.
Even debit spreads have assignment risk. If the short option is in the money, it can be assigned even if the long option is further in the money. If this isn’t unwound correctly, losses can get out of hand quickly.
There are lots of variations of spreads and combinations of multiple spreads. Condors, butterflies, and long ratios are some of the many ways spreads can be used in additional levels of complexity.
Spreads typically have limits to the upside and limits to the downside as well. Because the strikes are usually relatively close to each other, the difference between a full win and a full loss can be a fairly small move. The increased leverage of the position makes the risk higher than levels 0 and 1.
Level 3- Selling Naked Options
The highest levels of risk come from selling uncovered or naked options. Let’s quickly compare to other ways we sell options. In level 0, we had stock or cash in place to back up the options we sold. In level 2, we had a long option that countered or hedged our short option. With naked options, there is no coverage.
Most brokers force traders to reserve some buying power, usually around 20% of the notional value of the option to cover potential losses. Most of the time, that is more than sufficient. But, when a stock moves more than 20%, the broker requires more and more capital to be available to cover losses, and this can blow up an account by multiplying the amount of buying power required, just when the market is going against the option seller.
Traders selling naked options can go years without an issue, and then lose everything very quickly when complacent. Examples would be put sellers during the 2020 Covid crash or the 2008 financial crisis, or call sellers of so-called meme stocks like Tesla in 2020, or Gamestop in early 2021.
Assignment is very much a concern, and when assigned, often the position needs to be closed immediately to get the cash balances in line in the account. Because there is nothing covering the naked position, choices for unwinding an assignment are very limited.
In particular, naked calls truly have unlimited risk. There is no limit to how high a stock price can go up. An announcement of a merger, or an event that triggers a short squeeze can make a stock go up a multiple of it’s value in a short time and quickly eat up even a well-financed and otherwise conservative trading account. Stock values generally won’t fall below zero, so technically there is a limit for how much a put can lose, but calls have no limit.
Naked options have the potential to lose virtually unlimited amounts of capital in rare situations. Therefore, they are considered the highest level of option risk.
Futures and Futures Options
When considering trading risk, another type of trade to consider is Futures and Futures Options. Futures are contracts that allow the buyer or seller to own the obligation to buy or sell an underlying index or commodity at some point in the future. Often, these trades can be made in a highly leveraged way.
For most futures contracts, a trader can buy or sell a contract for a fraction of the underlying price of the underlying asset. For example, with Gold trading at $1500 per ounce, a futures contract buyer may only have to put up $75 an ounce in a contract. This is due to the use of span margin. Brokers account for the amount expected for the asset to move before expiration and only require that amount to enter a trade.
While this sounds like a great deal, if the price of the underlying asset moves more than expected, the broker will require more capital to cover the change in price. Losses can multiply quickly, so futures traders must be prepared and manage risk in their trades. Traders also have to keep in mind that the buying power required for futures does not begin to account for risk from outsized risks.
Because of thes high levels of risk, brokers require special permission to trade futures and futures options. Generally, these permissions are equivalent to level 3 permissions for regular options.
Conclusion
Option strategies vary in risk from strategies that reduce risk to those that multiply risk substantially. Understanding the levels of risk for different types of trades is critical for traders, as is having a plan to manage the risk of every trade.
For specific examples of risk profiles for different types of strategies, see my post comparing the risk of equivalent trades using different types of strategies.
