As with most investment vehicles, risk is inevitable. Options contracts are considered risky due to their complex nature, but knowing how options work can help reduce the risk level. Call options and put options essentially come with the same degree of risk.
Depending on which "side" of the contract the investor is on, risk can range from a small prepaid amount of the premium to unlimited losses. Investors who know how each work helps determine the risk of an option position.
Key Takeaways
- A put option and a call option are two types of options contracts.
- Depending on the contract, risk can range from a small prepaid amount of the premium to unlimited losses.
- The long call option poses less risk than the naked call option, which relies on the movement of the market price.
What Is an Options Contract?
"Puts" and "Calls" are two types of options contracts. Both can be purchased to speculate on the direction of a security or hedge exposure or sold to generate revenue.
A call option is a financial contract that givesthe buyer the right to buy a stock, bond,commodity, or other asset or instrument at a specified price within a specific period.A put option is a contract giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of anunderlying securityat a predetermined price within a specified timeframe.
Level of Risk
In order of increasing risk, the long call option poses the least amount of risk as compared to the naked call option, which relies on the movement of the market price to determine the cost and risk to the investor.
- Long Call Option: Investor A purchases a call on a stock, giving them the right to buy it at the strike price before the expiry date. They only risk losing the premium they paid if the option is not exercised.
- Covered Call: Investor B, who wrote a covered call to Investor A, takes on the risk of being "called out" of their long position in the stock, potentially losing out on upside gains.
- Covered Put: Investor A purchases a put on a stock they currently have a long position in. Potentially, they could lose the premium they paid to purchase the put if the option expires. They could also lose out on upside gains if they exercise and sell the stock.
- Cash-Secured Put: Investor B, who wrote a cash-secured put to Investor A, risks the loss of their premium collected if Investor A exercises and risks the full cash deposit if the stock is "put to them."
- Naked Put: Suppose Investor B instead sold Investor A a naked put. Then, they might have to buy the stock, if assigned, at a price much higher than market value.
- Naked Call: Suppose Investor B sold Investor A a call option without an existing long position. This is the riskiest position for Investor B because if assigned, they must purchase the stock at market price to make delivery on the call. Since the market price can be infinite in the upward direction, Investor B's risk is unlimited.
What Is a Strike Price?
The strike price on an options contract is the price at which the underlying security can be either bought or sold once exercised.
Why Do Investors Use Options Contracts?
Options contracts allow buyers to gain exposure to a stock for a relatively small price. They can provide substantial gains if a stock rises, but can also result in a total loss of the premium if the call option expires worthless due to the underlying stock price failing to move above the strike price.
What Determines the Price of an Option?
Options prices commonly depend on the market price, strike price, time to expiration, interest rates, and market volatility.
The Bottom Line
Options contracts are considered risky due to their complex nature, but investors who know how options work can reduce their risk. Various risk levels expose investors to loss of premiums, gains, and market value loss.
FAQs
When selling (writing) calls or puts, the most you can earn is the premium you get for selling the option, less commissions. In the case of selling naked calls, which means you don't own the underlying stock, there is risk of unlimited loss since there's no limit to how high a stock's price can go.
How risky are call and put options? ›
A put option and a call option are two types of options contracts. Depending on the contract, risk can range from a small prepaid amount of the premium to unlimited losses. The long call option poses less risk than the naked call option, which relies on the movement of the market price.
Why is options trading more risky? ›
Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher. Many options strategies are designed to minimize risk by hedging existing portfolios. While options act as safety nets, they're not risk free.
What is the riskiest type of option? ›
With naked options, the writer doesn't own the underlying asset. There is an unlimited risk of loss associated with selling naked calls if the price of the underlying asset shifts course. Naked puts come with the potential for losses even though the underlying asset's price can drop as low as $0.
Why is option selling more risky? ›
Selling options is riskier because your potential losses are uncapped. As the option seller, you receive the premium upfront but are obligated to buy or sell the underlying asset at the strike price if assigned. This exposes you to unlimited risk if the market moves against your position.
Is selling puts or calls more risky? ›
Selling uncovered puts.
The naked short put is also a high-risk position, but technically slightly less risky than a naked short call.
Which is safer call or put option? ›
The risk associated with trading either put or call options is based on the strategy used and market conditions. Buying either of these contracts is less risky than selling them, as purchasing call and put options limits risk to the premium paid, whereas selling can come with substantial risk.
Why do most people fail at options trading? ›
Most people fail at options trading because they have not taken the time to learn how options work and how volatility affects options pricing.
Are puts or calls riskier? ›
Even puts that are covered can have a high level of risk, because the security's price could drop all the way to zero, leaving you stuck buying worthless investments. For covered calls, you won't lose cash—but you could be forced to sell the buyer a very valuable security for much less than its current worth.
Why do people fail at options trading? ›
Failing to understand technical indicators
If you aren't familiar with the “Greeks” of options trading, it's best to understand them before getting started. For example, delta represents how much the option price is likely to move based on a $1 change in the underlying security.
The maximum loss is unlimited. The worst that can happen at expiration is that the stock price rises sharply above the put strike price. At that point, the put option drops out of the equation and the investor is left with a short stock position in a rising market.
Which is riskier stocks or options? ›
Options generally are a higher-risk, higher-reward opportunity than stocks. Investors considering them should know all their benefits and drawbacks.
Can you lose money options trading? ›
When you purchase an option, your upside can be unlimited, and the most you can lose is the cost of the options premium. Depending on the options strategy employed, a trader can profit from any market conditions. Options spreads tend to cap both potential profits as well as losses.
Should I avoid option trading? ›
Of all options, cheap options frequently have the highest risk of a 100% loss. The cheaper the option, the lower the likelihood is that it will reach expiration in the money. Before taking risks on cheap options, do your research, and avoid overpaying for options trades.
When to avoid option selling? ›
The risk comes if the market moves against your position. For example, if the stock's price skyrockets past the strike price of a call option you sold, you might have to buy the stock at the market price and sell it at the lower strike price, incurring a significant loss.
When to buy calls and puts? ›
Typically, you use call options when you think a stock will go up. You use put options when you think a stock will go down. While typical, this isn't always the case. You can express negative sentiment on a stock via call options and positive sentiment with put options.
Is buying put options risky? ›
In addition, puts are inherently less risky than shorting a stock because the most you can lose is the premium you paid for the put, whereas the short seller is exposed to considerable risk as the stock moves higher. Like all options, put options have premiums whose value will increase with greater volatility.
Are call options riskier than stocks? ›
Call options give buyers the right, but not the obligation, to buy a stock for a fixed price, on or before some date. Buying call options on a stock can be more profitable — but also more risky in percentage-change terms — than buying that stock itself.
Do call options have unlimited risk? ›
In buying call options, the investor's total risk is limited to the premium paid for the option. Their potential profit is, theoretically, unlimited.
Are calls and puts worth it? ›
Simply put, investors purchase a call option when they anticipate the rise of a stock and sell a put option when they expect the stock price to fall. Using call or put options as an investment strategy is inherently risky and not advised for the average retail investor.
