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The Risks of Buying Call and Put Options

Dec 22, 2020

Many options traders start out buying calls and puts; these are directional trades that allow you to control more of a stock with less capital, offering potentially unlimited profit potential with defined risk. Buying calls and puts is a pretty straightforward options strategy to understand and allows you to build experience and the skills needed to trade more complex options strategies.

The buyer of an American-style call or put option has the right, but not the obligation, to exercise the option on or before expiration. A call option gives the buyer the right to buy the underlying stock at the strike price of the option contract, on or before expiration. A put option gives the buyer the right to sell the underlying stock at the strike price of the option contract, on or before expiration.

Remember, just like buying and selling stock, you can buy a call or put option (open a position) during market hours at prevailing prices, and then sell your option contract (close your position) during market hours (prior to expiration) to take a profit or loss.

One of the advantages of buying calls and puts is knowing that your risk is limited to the amount you paid for the option. And generally, that is true. However, in options trading, nothing is ever quite that simple or exact. In this article we will look at the various risk factors associated with call and put buying.

Benefits of Call and Put Buying

Unlimited Profit with Limited Risk – Buying a call or put option offers unlimited potential profit and generally limits the maximum risk to the price of the option (premium paid).

Leverage – Options buying allows you to control a larger stock position with less capital than buying the stock directly. However, you should always apply the appropriate account risk and trade size management for each trade, factoring in your investment objective and overall risk tolerance.

Flexibility – When buying or selling stock, you can only trade two directions – up or down. Combining both buying and selling options in the same position offers a wider variety of market conditions you can trade, such as up, down, quiet markets, active markets, and increasing or decreasing volatility.

Measuring Day to Day P&L Risk

If you are writing a call option in a spread on a stock that pays a dividend, there is additional assignment risk if the call option is in-the-money and/or has less extrinsic (time value) than the dividend payout.

Delta (Price Risk) – a Delta value of .5 means the option premium will rise approximately .50 if the underlying stock goes up $1.00 in price. If the stock goes down $1.00, the option premium will go down approximately .50. You can use Delta to estimate how much the underlying stock must move in order for your position to reach a desired profit level, or get to breakeven, or hit a stop loss. Options with a Delta greater than .5 are generally in-the-money and have intrinsic value, and must be closed prior to expiration if you don’t want to exercise the option.

Vega (Volatility Risk) – a Vega value of .2 means the option premium will rise .20 if the volatility measure rises 1%. If the volatility measure goes down 1%, the option premium will go down approximately .20. You can use Vega to estimate the changes in the option premium for expected or estimated changes in volatility due to news events, earnings, or corporate actions. Vega is always a positive value, so rising volatility benefits both long calls and puts.

Theta (Time Risk) – a Theta value of -.25 means the option premium will decrease .25 each day that passes. Theta is always a negative number for long calls and puts. Options lose their time value as it gets nearer to the expiration date; this effect accelerates the closer expiration gets, with the last few days seeing the greatest loss of premium. It is a good rule of thumb to be out of a long options position before this accelerated Theta decay eats away the option premium.

Take the time to learn more about the Greeks and how they can help you assess and manage the risk for your options positions. Keep an eye on these three Greek measures whenever you are in an options trade. They can help you make key decisions for staying in a trade, or closing the trade, taking a profit or loss now, or waiting a few more days. Tools like OptionStation Pro in TradeStation can deliver these Greek metrics in real-time.

Do not get surprised on the Monday after options expiration

Option positions should not be ignored even if they appear to have little or no value. If a long call or put option is in-the-money (ITM) by as little as $0.01 at expiration, it will automatically be exercised for the buyer. You need to have enough cash, or available margin, to cover the underlying long or short position that will be placed into your account. If you don’t have enough funds in your account, you’ll be issued a margin call, which you must meet by adding funds to your account right away. But depending on the situation and timeline, the broker, at its discretion, has the right to liquidate any other position(s) in your account in order to meet a margin call.

When you don’t have enough money in your account to cover an exercise of a long option at expiration, you should consider closing that long position prior to expiration, even if that means a small loss, which will certainly be less than the trouble outlined above.

However, there is also something called a ‘Do Not Exercise’ (DNE) instruction that you can give to your broker that allows you to abandon an ITM option prior to expiration. DNE cancels the option contract in a way that can cause some trouble for a short seller of that same option, so whenever possible, you should consider closing your positions prior to expiration when you do not want to be auto-exercised.

But let’s say you do have enough funds to cover an auto-exercise of an outstanding options position. For example, you hold 10 long call options of XYZ stock at a strike price of $100. XYZ is trading at 99.95 by 100.05. It would cost you about a $50.00 loss to close this trade at the current bid – so you are hoping that it just expires worthless. The market closes with a trade at $100.05, which will trigger an auto-exercise.

There are three things you can do:

First, you can call your broker and give them the instructions ‘Do Not Exercise”. The option is abandoned, and you have no risk of auto-exercise over the weekend.

Second, you are too busy to call your broker and figure you will just deal with this on Monday by selling the stock at the open. On Monday morning, you now hold 1000 shares of XYZ long at a cost basis of $100 per share. Unfortunately, some bad news came out on XYZ over the weekend, and XYZ gaps down 20 points to $80 per share on the open. You are now down $2,000 on an option trade you thought had a maximum limited risk of just the premium you paid.

Third, depending on your broker, if you do not have sufficient equity in your account to support the exercise, your broker may either close the option for you prior to market close. Or, if the option closes ITM, your broker may force a ‘Do Not Exercise’ instruction on your long option position and prevent the exercise from taking place.

“Always pay close attention at expiration.”

Memory Risk

I cannot stress enough how important it is to remain engaged when you have an options position on, even just a long call or put. Options traders can get lazy when holding options positions for a few weeks or even longer periods of time. They can forget the expiration date or strike price and wake up one morning exercised and exposed to price action, or out of a forgotten position with a losing trade they didn’t expect. Avoid these mistakes. Keep close track of the contract specifications for any options you hold, and try to consistently react to changes in volatility and price action according to your trading plan.

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