Options Trading: The Risks and Benefits
Options trading has skyrocketed in popularity in recent years. Although this type of trading has existed since 1973, the retail investment boom following the Covid-19 pandemic has greatly increased its popularity. Call options also made the news when they helped drive the spike in GameStop and AMC stock prices in early 2021.
An options contract is simply an agreement that gives the buyer the right, but not the obligation, to buy or sell an asset at a specified time at a specific price. Options trading may allow investors to hedge their bets and reduce the risk of losses following significant fluctuations in stock prices. Options traders can also utilize options to speculate on the future price of a security. This type of trading is speculative and quite risky.
If your broker or investment advisor recommended a speculative options strategy that you did not understand or that led to significant losses, you may have a case against your broker or advisor. Investors who purchased options on the advice of a broker and lost money may have a case for a securities lawyer.
Options Trading 101
Option contracts comprise bundles of financial instruments—they can be stocks, bonds, currencies, or commodities. Most option contracts comprise 100 shares of a stock. Options are called derivatives because they derive their value from something else—their underlying shares. Buying options is different from buying stocks because investors are not buying the actual shares. Instead, these contracts give investors the “option” to purchase or sell an investment at a certain price by a certain date.
Calls and Puts
There are two basic forms of options:
Call options give the buyer the option to buy a stock at a certain price within a specified timeframe.
Put options give the buyer the option to sell a stock at a certain price by a deadline.
Put options offer a way to hedge against a stock portfolio. If an investor has long positions in the portfolio, meaning that they believe the stock prices of their shares will gradually increase over time, the put option gives them an option to sell those same shares at a higher price if the stocks eventually decline.
Options trading has its own lingo. These are a few important terms to remember:
- The “strike price” is the price at which the investor agrees to buy or sell their contract.
- Option contract sellers are called “option writers.” They take on risk, hence charging an upfront fee for the contract.
- The upfront fee is called a premium.
In the Money, Out of the Money, At the Money
When the option deadline arrives, options are either In the Money (ITM), Out of the Money (OTM), or At the Money (ATM).
- In the Money (ITM): The stock goes above the strike price. This is what you want if you buy a call option.
- Out of the Money (OTM): The stock price drops below the strike price. This is the ideal scenario for a put option.
- At the Money (ATM): The stock price is the same as the strike price. At this point, you would let your option expire regardless of whether you purchased a call or a put option.
Bearish and Bullish Trades
- Bearish options assume the price of the stock will decline.
- Bullish options are a gamble that the stock price will increase.
Covered and Uncovered Options
Options are either “naked” (a.k.a. “uncovered) or “covered.”
“Naked” or “uncovered” options are option contracts sold by option writers who do not own the underlying shares of the options contract. These are cheaper than regular options, but the price changes must be more extreme for the buyer to reach the strike price. If the buyer is correct about the price shift, the seller must buy the necessary shares for their call option or give them the cash for their put option. These types of options are obviously quite risky for the seller.
In a “covered” option, the seller owns an equal and opposite position of the contract that they write. Option writers might write these contracts because they expect the shares to gradually increase, but do not expect any big changes in the stock price. By writing a call option, a shareholder can generate some income in the short term.
Example of a Call Option
Imagine a buyer purchases a call option contract for a $5 premium. The option contract gives the buyer the right to purchase GameStop stock for $100, with a strike price of $150. When the deadline arrives, the price of GameStop has gone up to $155 per share. At this point, the buyer can exercise their right and purchase their GameStop stock for $100 and then sell it for $155.
$155 – $100 = $55
Remember, the buyer also paid a $5 premium for the contract. $55 – $5 = $50 total profit.
Example of a Put Option
With a put option, the buyer would assume that the price of GameStop would decline. In this example, a buyer purchases a share of GameStop at $100 with a strike price of $80. If GameStop shares reach $75, the investor gets to sell their shares for $100. Since $100 – $75 = $25, after paying a premium of $5, the investor gets to keep $20.
Letting an Option Expire
In both examples, the buyer takes on less risk than if they purchased an actual share. If the call option had not reached the expected price by the specified deadline, the buyer could simply allow the option to expire. If the investor had purchased a stock for $100, when the price declined to $80, they would have lost $20. With a call option, they only lost $5.
Selling an Option Contract
Buyers have a third option besides exercising their option or letting it expire. They can also sell their options contract. The Wall Street Journal reported that a new options trader saw an opportunity to make money with an options contract when he saw speculation about Robinhood shares increasing on message boards. He purchased a call option for $600 with a strike price of $35 per Robinhood share. He could exercise his call option once shares reached $70 per share. They did the next day, and he sold his option contract for $950, making $350 over just 30 minutes.
Are Options Less Risky Than Stocks?
The short answer is no. Options trading is tricky. The market is notoriously unpredictable, especially in the short term. It is difficult to know how much the market will move, especially by a certain expiration date. Option sellers statistically make more money than option buyers. Most option buyers will lose their entire investment.
But it’s easy to see why investors might see options as a low-risk strategy. Investors can buy options contracts for much less money than they could purchase the underlying shares.
Another problem with options investing: It may be tempting for investors to purchase many options at one time. For $5,000, instead of buying 500 shares of a stock that trades at $100 per share, an investor could purchase 500 options contracts at $10 each. Each option contract has 100 underlying shares, so the investor stands to profit from 50,000 shares. But, because all the options could easily expire out of the money, the investor stands to lose their entire $5,000.
Risky Options Can Lead to Major Losses
Investors claim to have suffered significant losses following recommendations from their UBS brokers to invest in an options trading strategy marketed as a “Yield Enhancement Strategy (YES).” This type of options trading is called an “iron condor,” which is riskier than the average option contract. It involves buying both short and long options, and it could theoretically produce a return for the investor in periods of low volatility. But volatility is always a risk—no one knows when the next pandemic, natural disaster, or economic crisis will strike. As any broker could have predicted, after a period of volatility, many UBS investors lost money.
If a broker recommended a risky iron condor strategy, they may have been motivated by the commission — as many investors alleged. Investors who believe their broker may have recommended an options strategy without considering their risk tolerance should consider contacting a securities lawyer for a free case evaluation.
Options Trading: Risk Management
Because options come with significant risk, your brokerage firm must approve you for options trading. If you believe that your broker approved you for options trading without factoring in your risk tolerance, you may be able to recover your losses through FINRA arbitration.
If you have questions about the suitability of your broker’s options trading strategy, do not hesitate to contact our securities attorneys.