Risks of Trading Options
Options can help protect you against the risks you face with some other types of investments, but they're not risk free. Before you invest, read this: Characteristics and Risks of Standardized Options.
Since options transactions usually open and close within a relatively short period, gains can be realized quickly. But losses can occur just as quickly. Before you include options in your investment portfolio, it's essential to understand the risks to which holding, writing, and trading options can expose you.
No investments guarantee that you'll make a profit or avoid losses. Options are no exception. In fact, with options, it's possible to lose all of the principal you invest, and sometimes more. As an options holder, you risk losing the premium you pay. But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call and are assigned to meet the obligation to sell the underlying stock, you face unlimited potential loss, since there is no cap on how high a stock price could rise.
However, since investing in equity options requires less initial capital than buying the equivalent amount of stock, your potential cash losses are usually smaller than if you'd bought the underlying stock and sold it at a loss. That isn't the case, though, if you use options to provide leverage.
Premium is the amount you must pay to buy an options contract or the amount you receive if you sell one. It's not fixed and changes constantly before expiration.
At any given time, an equity option's premium is determined by two separate factors. The first, its intrinsic value, is equal to the amount that the option is in-the-money. For example, if you hold a call with a strike price of 50 when the market price of the underlying stock is $52, the option's intrinsic value is $2. A contract that isn't in-the-money and can't be exercised at a profit has no intrinsic value.
However, all unexercised contracts have time value. That's the dollar value investors assign to the time left until expiration. The longer the time, the higher the time value is. That's because there is a greater possibility that the underlying stock price will change and the option will end up in-the-money.
The entire premium of an at-the-money or out-of-the-money option is its time value, since its intrinsic value is zero. In contrast, the entire premium of an in-the-money option at expiration is its intrinsic value, since the time value is zero.
Options investors face another risk: time decay. In fact, options are described as wasting assets because their value drops as the expiration date approaches and vanishes when that date arrives. In contrast, stockholders, even if they experience a dramatic loss of value on paper, can hold onto their shares over the long term. While the company continues to exist, its shares have the potential to regain value.
You might say time is a luxury for stockholders. But it is a liability for options holders. If the underlying stock or other instrument moves in an unanticipated direction, the time available for a correction is limited. Once the option expires out-of-the-money it's worthless, and you, as the holder, will have lost the entire premium you paid. Options writers, on the other hand, like nothing better than having the contracts they write expire unexercised and out-of-the-money. Then they keep the premium.
Since options are wasting assets, losses and gains occur in short periods. If you followed a buy and hold strategy, as you might with stocks, you'd risk missing the expiration date or an unexpected event. It's also important to fully understand all potential outcomes of a strategy before you open a position. And once you do, you'll want to be sure to stay on top of changes in your contracts.
- Since an option's premium may change rapidly as expiration nears, you should keep close tabs on the status of your contracts and decide whether it makes financial sense to close out a position.
- You should be aware of any pending corporate actions, such as splits and mergers, which might prompt contract adjustments. You can find that information on the Option Industry Council's website, www.OptionsEducation.org.
The Tax Impact
The tax issues associated with options transactions can be complicated. For one thing, options contracts vary by the type of underlying security and the specifics of the transaction. It's not a one-size-fits-all situation. And the tax rules that apply depend on the particular contract.
Another thing to keep in mind is that short-term gains you realize on securities you have held for less than a year are taxed at a higher rate than long-term gains, or gains on securities held longer than a year. Since most options are traded or exercised within a matter of weeks, in general the gains you realize will be short term, and may be taxed at the same rate as the tax on your ordinary income. But you may be able to use short-term losses from options trading to offset short-term gains on other securities. That could help reduce the taxes you owe.