Clemen Langston on Managing Risk in Option Buying

Clemen Langston on Managing Risk in Option Buying

1. Loss of Premium
   As a buyer, you need to pay the option premium upfront. If the option expires without intrinsic value (i.e., the underlying asset's price is below the strike price for a call option or above the strike price for a put option), the option will become worthless and the buyer will lose the entire premium. Simply put, if you buy a call expecting a price increase that doesn't happen or buy a put expecting a drop that doesn't occur, the buyer loses the full option premium which is the biggest risk.

1. Time Decay
   Options are contracts with a time limit, and their time value decreases as the expiration date approaches. Even if the underlying asset's price moves in the expected direction, if the movement is too small or occurs too late, the option buyer may still be unable to profit. This time decay works against the buyer. The closer the contract is to expiration the more disadvantageous it is for the buyer.
   Example: You expect the stock price of XX to rise in the short term, so you buy a call option with three days left until expiration. On the first day, you buy it for $9 (cost basis), but the price movement is minimal providing insufficient profit. On the second day, with little change in the underlying asset's price, your option is now even closer to expiration, causing a steep reduction in time value. The option's opening price drops to $6 (current price) meaning you've lost 33% purely due to time decay. Even if the underlying asset price eventually rises, the gain may not be enough to recover the $3 lost due to time decay leading to a net loss. This is one reason why traders are wary of options close to expiration.
2. Insufficient Market Volatility
   Market volatility is one of the key factors affecting option prices. If volatility decreases, the value of the option may decline resulting in a loss for the buyer. Even if the underlying asset moves in the expected direction a lack of volatility may still prevent the buyer from profiting.
3. Implied Volatility Risk
   Option prices are influenced by implied volatility. If implied volatility in the market drops, the option's price will also decrease, causing unrealized losses for the option buyer.
   Summary: As buyers we pay the option premium upfront and if there's no chance to earn back the premium, that money is essentially lost. Additionally, we must contend with factors like time decay, volatility, and other variables that can affect the price of the option. This makes the odds of success naturally lower for buyers and it can be more difficult to profit. While options provide unlimited profit potential, there are certain barriers to entry.