Why Is Options Trading Dangerous?

Today we’re going to talk about why options trading can be a risky business. Now, before we get started, let me just say that options trading isn’t inherently bad. In fact, it can be a great way to make money if you know what you’re doing. But if you don’t, you could be in for a world of hurt. So, let’s dive in!

First things first, let’s define what options trading is. Essentially, an option is a contract that gives the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price, on or before a certain date. Now, this might sound like a good deal – you get to buy or sell an asset at a fixed price, regardless of market conditions. But the catch is that you have to pay for the option upfront. And if the asset price doesn’t move in the way you predicted, you could end up losing that money.

Now, let’s talk numbers. According to the Options Clearing Corporation, the total options trading volume in the U.S. in 2020 was 7.47 billion contracts. That’s a lot of trading! And while the majority of those trades may have been successful, there are plenty of horror stories out there.

Selling Options Can Lead to Unlimited Losses

For example, in 2018, a trader at an investment fund called OptionSellers.com lost more than $100 million in a single day due to a short call option strategy gone wrong.

Essentially, he was selling options. Selling options can be a great way to generate income. You generate a “premium” at the sale and because most options expire worthless, you can usually get to keep that premium.

But selling options is a lot like insurance. You collect nice premiums every month and get to pocket it. But sometimes there’s a hurricane and you have to pay out a ton of claims. So if you didn’t manage things well before the hurricane hits, you can end up losing more in one trade than all of those previous trades.

The seller of an option exposes themselves to potentially unlimited losses. When selling an option, you agree to buy or sell the underlying asset at an agreed-upon price, regardless of how much the asset’s price moves against you. For instance, if you sell $50 strike call option, you’re still on the hook to sell shares at $50 even if the stock goes to $1000/share.

And this is basically what happened to James Cordier of OptionSellers.com. He was short crude oil and natural gas options and the prices moved against him rapidly. As most people know, the price of natural gas can very rapidly multiply in short time. As a point of demonstration, the price of natural gas was above $7 in December 2022 and was below $3 by January.

Option sellers can protect themselves by using spreads like vertical spreads and iron condors to sell options in a risk-defined way. This way, you know the maximum you can lose before you put the trade on. After becoming very experienced in this, then you can move onto selling options outright.

And by the way, James Cordier and the madness that occured at OptionSellers.com is not an isolated incident. In 1995, a trader named Nick Leeson famously brought down the venerable Barings Bank through a disastrous options trade. And just last year, the trading app Robinhood faced criticism for allowing inexperienced traders to make risky options bets, resulting in some users losing significant amounts of money.

Explaining Why Options Trading Is Dangerous

So, what makes options trading so dangerous? For starters, it’s complex. Options trading requires a deep understanding of market conditions, asset prices, and risk management strategies. And even if you do have that knowledge, there are still plenty of variables that can’t be predicted, such as unexpected news events or sudden shifts in market sentiment.

Another problem with options trading is leverage. Options contracts allow you to control a large amount of an asset with a relatively small upfront payment. This can be great if the asset price moves in your favor – you can make a lot of money with a small investment. But if the price goes against you, you could lose much more than you initially put in. For example, if you buy a call option on a stock for $1,000 and the stock price drops, you could lose the entire $1,000 – even if the stock only drops a few dollars.

How To Avoid Disaster When Trading Options

So, what can you do to protect yourself if you’re interested in options trading? First, educate yourself. Learn as much as you can about options trading, including the risks and potential rewards. Don’t rely on social media or message boards for your information – seek out high authority sources, such as the free education available from high-quality sources like the Options Industry Council or Chicago Board Options Exchange.

Second, start small. Don’t jump into options trading with a large amount of money right away. Start with a small amount and see how it goes. This will help you gain experience and confidence without risking too much.

Modern stock brokerages allow you to open a trading account with as little as 1 and commissions on options trades are as low as $0.60/trade. I’m pretty sure they’re even free at Robinhood. There’s no excuse not to start small.

Third, use risk management strategies. Options trading can be risky, but there are ways to mitigate that risk. For example, you can limit your losses by setting stop-loss orders or using options spreads to hedge your bets.

Even history’s best traders have a deep respect for risk management. While the media loves to point to famous trades where traders “pushed all the chips in the middle” like George Soros’ famous trade where he broke the Bank of England, the reality is that the vast majority of his trades are small in size with stop losses in place.

Bottom Line

In conclusion, options trading can be dangerous if you don’t know what you’re doing. It’s a complex and risky business that requires a deep understanding of market conditions, asset prices, and risk management strategies. And even if you do have that knowledge, there are still plenty of things that can go wrong. That’s why it is critical to always size your trades properly.

from Ridgefield – Stock Trading Blog https://ridgefieldacquisition.com/why-is-options-trading-dangerous/
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