What are the risks of options trading?

Options trading can be an incredibly useful, versatile tool once you understand the basics. But they can also carry significant risk depending on how you use them, and how they can fit your trading strategy.

Options can be used speculatively to maximize profits, while potentially limiting the amount of capital you have to risk, or they can be used as hedging strategies to reduce risk on an already existing position.

Options trading is not suitable for everyone. You should carefully consider whether trading is appropriate for you in light of your experience, objectives, financial resources and other relevant circumstances.

As Warren Buffett once famously said “Risk comes from not knowing what you’re doing.” Before trading Options, make sure you understand the potential risks, obligations and rights that come with buying, or selling Calls and Puts. 

Here are some common tips and tricks, and common risks to watch out for when getting started with options trading:

When buying or selling options for the first time, many traders will notice that the difference between the Bid price and the Ask price can be quite large (sometimes called a ‘wide’ spread) compared to the underlying stock. This all depends on the volume of the options contract (how many contracts are trading hands between traders), and the open interest (how many contracts are ‘out there’ in the market).

Since the same underlying asset will have hundreds of different combinations of Strike prices, and Expiration dates, the open interest, and volume can vary significantly between options for the same security.

Between different underlying assets, how “popular” the Stock, ETF or Index is can also have a big effect on the volume and open interest.

For example: Options contracts on a small-cap Canadian company will have much lower volume and open interest than options contracts on the SPX.in (S&P 500 index).

Many Call or Put options will expire worthless if they are not “in-the-money” by the end of the trading day on expiration. Therefore as the buyer of the option, you risk losing your entire investment (the premium you paid originally).

Zero-day (sometimes called 0DTE or ‘days till expiration) Options are Calls and Puts that expire on the same day they’re bought or sold.

Since these options will have little to no Time value, their prices are completely determined by the percentage of implied volatility, and any intrinsic value (whether it’s in, or out-of-the money).

Whether you’re an option buyer, or seller, this “ticking clock” of zero-day options adds an additional element of risk (or protection in rarer cases). A zero-day option can have some time value at the start of the trading day, but if it’s “OTM” as 4pm approaches, this rapidly drops to $0.

Check out our Options FAQ for more information on common questions about zero day options.

Compared to buying (or going long) an option, where the maximum loss is the premium paid, writing (or going short) an option is much riskier (in most scenarios).

When you write an option, you take on the obligation to buy or sell shares at the strike price if called upon to do so (assignment), no matter what the current price per share is.

For example: You write a Call option on Stock XYZ trading at $10 with a strike price of $12, and you don’t own shares of XYZ (this is referred to as an “uncovered, or naked call”).

Due to unexpected popularity on online message boards, XYZ unexpectedly rises in price to $100. As the original Call writer, you will be assigned, and due to your obligations, you now must sell 100 shares of XYZ at the strike price.

But since you don’t own the shares, you are forced to immediately take a short position of -100 shares of XYZ to satisfy the obligations of the Call. When you take this short position, the 100 shares are sold to the Call buyer at the Strike price of only $12.

The short position will start off with a negative P&L of -$8,800.

If the short position is not possible (due to inventory, liquidity, or volume), you may be forced to buy 100 shares at $100 each in the open market for $10,000 (representing 1 call contract). Which are then sold for only $12 each for a total loss of -$8,800.

Writing “Uncovered Calls” exposes you to unlimited losses, while the maximum profit will only be the premium received.

Writing options is limited by an account's Options Level. Generally speaking, only a limited number of short/writing strategies are permitted in Registered accounts.

To trade options, you must first enable this in your account. Check out the article linked above for more details on enabling options, the various strategies and what level they're organized under.

Depending on if your option is ITM, or OTM, and whether you’re the buyer, or the writer, you may have certain obligations, or rights on expiration day.

These actions you take on the expiration date can have a significant impact on your overall profit and loss.

Please check out our Options FAQ for more information about what happens to your option on expiration day.

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.