Module 7: Options Risks and Basic Risk Management

Options trading comes with unique risks. Understanding and managing these risks is crucial for long-term success:

Understanding Leverage in Options

Leverage allows you to control a large amount of stock with a relatively small investment.

How it works in options:

• The price of an option is much less than buying the equivalent amount of stock outright.
• This means that percentage gains (and losses) on the option investment can be much more significant than on the stock itself.

Example:

• Stock XYZ is trading at $100. A call option with a strike price of $105, expiring in 3 months, costs $3.
• To control 100 shares, you'd pay $300 for the option instead of $10,000 for the stock.
• If XYZ rises to $110, the option might be worth $7, a 133% gain on your investment compared to a 10% gain on stock.
• However, if XYZ falls to $95, the option might become worthless, a 100% loss vs. the stock's 5% loss.

Key takeaway: Leverage amplifies gains and losses, increasing potential returns and risks.

The Risk of Losing Your Entire Investment

Options have an expiration date, after which they become worthless if not exercised.

Scenarios leading to total loss:

• Out-of-the-money options at expiration: If a call's strike price is above the stock price (or a put's strike is below) at expiration, it expires worthless.
• Incorrect market direction: If you buy a call and the stock price falls (or buy a put and the price rises), you could lose your entire premium.

Probability factors:

• Time to expiration: Shorter-term options have a higher risk of expiring worthless.
• Distance from the strike price: Further out-of-the-money options are more likely to expire worthless.

Example:

• You buy a $50 call option on stock ABC for $2, expiring in 1 month. ABC is currently at $48.
• If ABC is trading at $49.99 at expiration, your option expires worthless, and you lose your entire $2 investment.

Key takeaway: Unlike stocks, which can recover from downturns, options can become completely worthless.

Time Decay Risk

Time decay is the reduction in an option's value as it approaches expiration, also known as theta.

How it works:

• Options lose value over time because there's less opportunity for the stock price to move favourably.
• This decay accelerates as the expiration date approaches, especially in the last month.

Factors affecting time decay:

• Moneyness: At-the-money options typically experience the most time decay.

• Time to expiration: Decay accelerates as expiration nears.

Visualizing time decay:

• Think of it like an ice cube melting: slow at first, then rapidly as it gets smaller.

Example:

• You buy a $60 call option on stock DEF for $3, expiring in 3 months. DEF is currently at $58.
• After 2 months, even if DEF is still at $58, your option might only be worth $1.50 due to time decay.

Key takeaway: Time constantly works against the option buyer, eroding the option's value.

Volatility Risk

Volatility risk is the risk associated with unpredictable changes in the rate and magnitude of price movements for the underlying asset.

Why it matters for options: Changes in volatility can significantly affect option prices, even if the underlying asset's price remains unchanged.

Types of volatility:

• Historical volatility: Measures past price fluctuations of the underlying asset.
• Implied volatility (IV): The market's forecast of future volatility derived from current option prices.

How it affects option prices:

• Higher IV = Higher option prices (both calls and puts)
• Lower IV = Lower option prices

Volatility skew:

• Out-of-the-money puts often have higher IV than out-of-the-money calls, reflecting market fear of downturns.

Example:

• You buy a call option on stock GHI for $4 when IV is 30%.
• Positive news reduces market uncertainty, dropping IV to 20%.
• Even if GHI's stock price has remained unchanged, your option might now be worth only $3 due to the IV decrease.

Key takeaway: Changes in market expectations about future volatility can significantly impact option prices, regardless of the underlying asset's price movement.

Basic Risk Management Techniques

Position Sizing:

• What: Limiting the amount invested in any single option trade.
• How: Limit the size of a single trade to an appropriate risk level to ensure only a small, manageable percentage of your portfolio is at risk per trade.
• Why: Protects your portfolio from significant losses on any one trade.

Diversification:

• What: Spreading risk across different stocks, sectors, and strategies.
• How: Use options on various underlying stocks and mix different option strategies.
• Why: Reduces the impact of a single bad trade or sector-specific issues.

Stop-Loss Orders:

• What: Setting predetermined exit points to limit potential losses.
• How: Place an order to sell your option if it drops to a certain price.
• Why: Helps manage emotional decision-making and limits downside risk.

Continuous Education:

• What: Ongoing learning about options, market dynamics, and trading psychology.
• How: Read books, attend webinars, practice paper or virtual trading.
• Why: Markets and strategies evolve; staying informed improves decision-making.

Using Spreads:

• What: Combining options to limit risk (e.g. bull call spread).
• How: Buy one option and sell another with a different strike price.
• Why: Reduces both cost and risk compared to buying options outright.

Example:

Let's use "CanTelecom Services," a fictional company in the Communication Services sector, trading at $80:

• You buy a call option with a $85 strike price for $3, expiring in 2 months
• Total investment: $300 ($3 × 100 shares)

Risks:

• Leverage Risk: If CanTelecom drops to $79 (1.25% decrease), your option might lose 33% of its value
• Total Loss Risk: If CanTelecom stays below $85 at expiration, you lose the entire $300
• Time Decay Risk: Your option loses value each day, especially in the final weeks
• Volatility Risk: A decrease in market volatility could reduce your option's value, even if CanTelecom's price doesn't change

Risk Management:

• Limit your position size to a small percentage of your portfolio (e.g., 1-2%)
• Diversify by also considering put options or options on other telecom companies
• Set a stop-loss order: This is an instruction to sell the option if its price falls to a certain level. For example, you might set a stop-loss at 50% of the option's initial value. If you paid $3 for the option, you could set a stop-loss at $1.50. This helps limit potential losses.
• Consider paper trading (practicing with simulated or virtual money) to gain experience before using real funds.

Exercise

2. True or False: Time decay (theta) affects all options equally, regardless of how close they are to expiration.

3. If you've invested $500 in a single options trade, and your total portfolio is $10,000, what is your position size as a percentage?

1. 0.5%
2. 5%
3. 10%

Answers: 1) c, 2) True, 3) b

Remember, while options can offer significant profit potential, they also come with substantial risks. Always use risk management techniques and invest only what you can afford to lose.

Well done on completing Module 7! You've now gained crucial knowledge about the risks involved in options trading and how to manage them. This understanding is vital for any successful options trader. In Module 8, we'll explore how to open your first options trading account in Canada. Ready to take the next step towards becoming an options trader?

Disclaimer:

The strategies presented in this article are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

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