What are the Risks Involved in Options Trading?

Last Updated: 9 Jan 2025

Any trading in the capital markets is risky and there is no getting away from it. The best you can do is to smartly and prudently manage this risk. Options trading risks arise for the buyer to a lesser extent and the seller to a larger extent. Here we break up options risks into buy-side risks and sell-side risks and look at them separately. Remember, there is risk in options trading, irrespective of whether you are a buyer or a seller. Even as a buyer, you cannot keep on losing premium so that becomes a risk in options trading. Let us look at options risks in detail here.

Understand the Risks Involved in Options Trading?

When you buy or sell options what are the Options trading risks that you are exposed to? Traders often believe, and erroneously, that buying options is free of risk. Let us say you buy options and lose your premium once it is OK. However, the real Options trading risks can arise even on the buy side if your buy options consistently bomb and eat away a good chunk of your trading capital. Also, when you are the buyer of an option, the time value works against you. That means; even if the price is constant, you keep losing time value and the value of the option keeps going down. But the real risk in options is in writing, so we focus elaborately on the selling side of options risks.

Key risks of writing/selling options

You must remember that writing/selling options in the Indian market, or anywhere else in the world, entails unlimited risk if the price movement is against you. For example, if you sell an Rs.200 call at Rs.5 and the price goes to Rs.300, then you effectively lose Rs.95. That is huge. This risk is true irrespective of whether you are selling/writing options on stocks or indices like the Nifty and Bank Nifty. Let us now turn to some key risks of option writing.

1. Unfavorable price movements can work hard against you. We go back to the previous case. If you sell a call option and if the price shoots up, you run a huge risk. Similarly, when you sell put options and the price crashes, you run a huge risk. You can protect against such unlimited losses with the help of stop losses, but the overnight risk is still a reality for you when you sell options. There is no answer to the problem, as that is the nature of options, You just need to manage your risk of writing options better.
2. Even if the price is constant, a spike in volatility can work against you. How exactly does that happen? Remember that when you buy options, volatility works in your favor. However, when you sell options the same volatility works against you! Let us understand this point in greater detail. Let us assume that sold a 250 call on stock at Rs.10. The price on Thursday is Rs.8, so you are comfortable. However, on Friday, the volatility goes up sharply and the option premium of the same call options has shot up from Rs.8 to Rs.14. Now you are sitting on a loss of Rs.4 and that will have to be compensated by you as higher MTM margins. That is the risk you are exposed to by volatility, even if the price does not exactly go against you.
3. Higher initial Margin risk is the big risk in selling or writing options. When you buy options, you pay premium margins, which is the maximum loss on the transaction. However, when you sell options your losses can be potentially unlimited just like a long or short futures position. Hence initial margining for writing options is like futures. You are charged the (SPAN margin + exposure margin) as part of your initial margin when you sell options. That is an opportunity cost. In addition, daily MTM margins also have to be taken care of.
4. Finally, let us dwell briefly on the MTM or mark-to-market margins in selling options. This applies to selling calls or puts. You need to fill up the MTM margins when the price movement goes against the seller. The practice is that when the total margin including MTM goes below the maintenance margin, the broker makes a margin call. This is a risk in terms of liquidity management for the seller of the option.

In the past, stock options in India used to be American options, and index options used to be European options. In American options, since they can be exercised at any time before exercise, there was the daily assignment risk for option sellers. The assignment is done randomly, so if you have written a call or put which is current in-the-money or ITM, you stand the risk of the option being assigned to you randomly. However, effective from 2010, all options have moved to European options so the assignment risk does not exist any longer.

Different option trading strategies

Options trading strategies can be protective like protective puts. Options strategies can also be cost-reducing like covered calls. Options strategies can also be volatile like long straddles and long strangles. Options strategies can also be rangebound in style like short straddles and short strangles. Finally, options strategies can also be moderately bullish or moderately bearish like a bull call spread or a bear put spread respectively.

Benefits of option trading

Options trading have a few interesting benefits. Firstly, they allow you to hedge or protect your risk and define your maximum loss. Secondly, options trading also allows you to take a speculative position in the market by just risking the premium amount. Finally, options trading can also be used for limited risk strategies by combining different options.

Frequently Asked Questions

Are options high risk?

That would depend on whether you are buying options or selling options. When you buy options, your risk is limited to the premium paid. However, when you sell options, your risks are unlimited although your income is limited to the premium earned only.

Can you lose all your money in options?

That really depends on what you mean and how you trade. For example, when you buy options, it is possible to lose the entire premium if your option expires worthless and you don’t close your option position on time. Secondly, when you sell option, you need to have a hedged position or you must do so with strict stop losses to avoid losing your capital. Selling options can be a lot riskier in terms of losing capital.