Summary:
Different types of market participants trade options for various reasons, depending on their goals, capital availability and risk appetite. This blog takes a look at why option buyers tend to keep losing money and how that can be avoided.
Who invests in options
Different types of market participants trade options for various reasons, depending on their goals, capital availability and risk appetite. Individual investors, institutional investors, market makers, speculators, hedgers, employee stock option holders, arbitrageurs, options traders on stock exchanges and risk managers are among the different types of market participants who trade in options. But what baffles most newcomers is why most options buyers lose money. This blog should help clear things up.
What leads to losses while buying options
Like other forms of investments, options trading carries inherent risks and complexities. Traders should have a good understanding of the options market and associated strategies before participating. Also, options trading may not be suitable for all investors. Options buyers can incur losses for several reasons, primarily related to the characteristics and dynamics of options contracts. Here are some common reasons why options buyers lose money:
- Time decay (Theta): Options contracts have a limited lifespan, which ends on the expiration date. As options approach their expiration date, they lose value due to time decay (theta). The closer an option is to expiration, the faster its time value erodes. If the underlying asset's price doesn't move in the desired direction quickly enough, options buyers can suffer losses as the time value diminishes.
- Lack of price movement (low volatility): Options provide leverage, which means that a small price movement in the underlying asset can lead to significant gains or losses in the option's value. If the underlying asset remains relatively stable or experiences minimal price movements, options buyers may incur losses, particularly if they have paid a premium for the options.
- Not achieving the strike price (out-of-the-money): In the case of options, there are two main types: call options and put options. With a call option, the buyer has the right to purchase the underlying asset when the strike price is achieved, while a put option gives the buyer the right to sell it at the strike price. For options to be profitable, the underlying asset's price must move in the expected direction and cross the strike price (in-the-money). If the price fails to do so, the options may expire worthless.
- Overpaying for options (high premiums): Options premiums can be influenced by factors such as volatility, time to expiration and the distance between the current asset price and the strike price. If options buyers pay a high premium for their contracts, they may need a larger price movement in the underlying asset to offset the premium cost and achieve profitability.
- Transaction costs: Trading options involve transaction costs, including commissions and fees. These costs can eat into potential profits and make it more challenging to achieve profitability, especially for small price movements.
- Unforeseen events: Unexpected events, such as news releases, earnings reports, or economic developments, can lead to sudden and sharp price movements in the underlying asset. These movements can result in losses for options buyers if they do not anticipate, or react to the events effectively.
- Holding options until expiration: If options buyers hold their contracts until expiration and they are out-of-the-money (i.e., the underlying asset's price has not moved in their favor), the options will expire worthless, resulting in a total loss of the premium paid.
- Lack of a clear strategy: Options trading requires a well-defined strategy. If options buyers do not have a clear plan, exit strategy or risk management in place, they may make impulsive decisions that lead to losses.
Minimising losses:
Despite apprehensions, there are ways in which options traders can exercise caution and minimise, as well as mitigate losses. The following are some of the things that can help to not lose money while buying options:
- Position sizing: Determine the appropriate position size for each trade based on your risk tolerance and overall portfolio size. Avoid overcommitting to a single trade.
- Use stop-loss orders: Stop-loss orders are able to minimise potential losses. When a specific price is reached, a stop-loss order will execute an exit from the trade if it moves against you. This helps prevent significant losses.
- Risk-defined strategies: Consider using risk-defined options strategies, such as vertical spreads, iron condors or butterflies. These strategies limit your potential losses to a known and manageable amount.
- Avoid naked options: Naked (uncovered) options positions have unlimited risk. Stick to strategies that involve both buying and selling options, which can help offset potential losses.
- Monitor and adjust: Continuously monitor your options positions and be prepared to adjust or exit trades if market conditions change. Have a plan for managing losing positions.
- Implied volatility: Pay attention to implied volatility levels. High implied volatility can lead to inflated options premiums, making it more challenging to profit. Consider selling options when implied volatility is high and buying when it's low.
- Time management: Be mindful of time decay (theta) when trading options. Avoid holding options until expiration if they are out-of-the-money, as time decay accelerates as expiration approaches.
- Avoid speculation: Avoid purely speculative trading without a well-reasoned strategy. Make informed decisions based on analysis, not emotions or hunches.
- Hedge positions: Use options to hedge existing positions in stocks or other assets. This can reduce the risk of large losses if the market moves against you.
Summing up:
Even though no strategy is foolproof, mitigating the risks associated with options trading requires a solid understanding of options, the use of risk management techniques (such as setting stop-loss orders) and taking into factors such as time decay, volatility and transaction costs when making trading decisions. Careful analysis and research to make informed predictions about the underlying asset's price movements, along with the steps outlined in this blog should help you not lose money when buying options.