Options can be a useful tool in an investor’s portfolio, but they can also be “weapons of mass destruction” for investors. There are many options strategies, and they run the gamut from being somewhat conservative to downright speculative. Brokerage firms, in the interest of generating commissions, oftentimes neglect to disclose the numerous risks associated with trading in options.
Options are complex securities. There are put options (which gives the investor the right to sell a specified number of shares of a stock at a stated price) and call options (which gives the investor the right to buy a specified number of shares of a stock at a stated price), and you can buy or sell either. Options have expirations date, or they can be exercised, or they can be “closed out” by the investor. Options can be in the money, or out of the money. There are also a number of different strategies involving the use of different types of options: Spreads, Straddles, Risk Reversal. In short, trading in options is complex and confusing and requires knowledge.
For knowledgeable investors, the benefit of options lies in their versatility. Trading options allows an investor to quickly adapt or adjust their position according to different situations that arise in the market.
Many investors see the relative low price of options as compared to the underlying security and think it makes for a good investment. For example, stock of company ABC costs $50 per share. Therefore, if you wanted to buy 100 shares of ABC, you’d have to pay $5,000 (all numbers used herein are before commissions). On the other hand, one call options contract that controls 100 shares of company ABC costs $2. Therefore, to purchase the option equivalent of 100 shares of ABC you’d pay $200. If your belief in stock ABC pans out and increases in value, you would make more money from your investment in the option than if you had purchased the stock.
Other investors use options as a way to reduce potential risk. In the example above, if you bought 100 shares of stock ABC, you could lose all the money you invested – $5,000. On the contrary, if you invested in one call option contract of stock ABC, the most you could lose would be $200. That is quite a difference.
Other investors look to options as a way to hedge against market loss. If you own 100 shares of stock ABC, you have no protection if the market should suddenly drop in value. In particularly turbulent times, employing hedges can be a wise thing. Imagine if stock ABC fell from $50 per share, the price you paid, to $8. Suddenly you would face a $4,200 loss.
You may have anticipated this and purchased, along with the stock, one put option for a price of $5 per contract, or $500. This put option gives you the right to sell the underlying 100 shares at the strike price of $40. Therefore, you have limited your overall loss to $700.
Brokerage firms also tout selling covered call options as a way to generate income. The idea here is that if you own stock ABC, you can sell call options on that stock to bring in cash to the account. Of course, if the market moves too quickly you could wind up having your shares of ABC stock “called” from you.
Below are just some of the risks that brokerage firms often overlook in disclosing material information to their investors.
For options buyers:
- Risk of losing your entire investment in a short period of time.
- The risk of losing your entire investment increases as the option goes out of the money and as expiration nears.
- European style options that do not have secondary markets on which to sell the options prior to expiration can only realize its value at expiration.
- Regulatory agencies may impose exercise restrictions, which stop you from realizing value.
For options sellers:
- Options sold may be exercised at anytime before expiration.
- Covered call traders forgo the right to profit when the underlying stock rises above the stock price of the call options sold and continues to risk a loss due to a decline in the underlying stock.
- Writers of naked calls risk unlimited loss if the underlying stock rises in value.
- Writers of naked puts risk unlimited loss if the underlying stock drops in value.
- Writers of naked positions run margin risks if the position goes into significant losses.
- Writers of naked call options are obligated to deliver shares of the underlying stock if those call options are exercised.
Prior to buying or selling an option, brokerage firms are required to provide investors with the brochure Characteristics and Risks of Standardized Options. As its name would imply, this booklet explains options and the risks attendant in trading them. If after reading this you still have questions, you should think twice about investing in options.
In summary, trading options is a complicated and speculative endeavor. Because options have exercise dates, they require constant monitoring. If there is a sudden and dramatic change in the market, this can cause any options strategy to have to be quickly revaluated and changed. There is also the cost of trading options. Options are short-term investments that oftentimes require active buying and selling. Commissions can quickly eat into any profit an investor may expect to realize.
If you have investment losses or problems involving options, call the lawyers at Page Perry for experienced representation at (770) 673-0047 or (877) 673-0047 (toll free).