Know the benefits and critical risks faced by buyers and sellers in the options market; and know how to access the OCC’s ODD and be mindful that their strategy and investment objective in the market will largely dictate their potential benefits and assumption of risk.
You should now have a better understanding of the basic components of stock option contracts, as well as the common language used by buyers and sellers of these products.
Now you may be asking: ‘What do I have do gain or lose by trading in this market?’
Before buying or selling an option, you should note that, as a rule, investors are required, among other actions, to read a copy of the Characteristics and Risks of Standardized Options, also known as the ‘options disclosure document’, or ODD.
This booklet, which relates solely to options issued by the Options Clearing Corporation (OCC), provides insights into the options market, including the risks faced by both buyers and sellers, margin requirements, tax considerations, and other topics.
Among other functions and services, the OCC serves as a central counterparty in all listed options transactions, meaning it provides a guarantee that a trade will settle, should an option writer fail to satisfy their part of the contract.
You can find out more about the OCC from their website, as well as obtain the options disclosure document.
In general, the advantages and risks of trading options mainly depend on your reason for using them.
Are you looking more at generating additional income, for example, or hedging an existing position? Are you bullish or bearish on the market and want to speculate on a stock price over a fixed period of time?
While we’ll dig more deeply into these subjects later in the course, it’s important to note that what you stand to gain or lose in the options market is largely tied to your market strategy, as well as at what price the underlying security needs to be for you to breakeven – that is neither gain nor lose on your investment.
Some of the main motives for options traders to enter the market include the potential for enjoying unlimited gains at a relatively lower cost than buying the underlying security outright in the stock market, as well as generating additional income, and protection against existing exposure.
Potential losses & gains
Taking a closer look at the four basic options contracts, we can see that, as a buyer, your maximum gain is equivalent to the seller’s maximum loss – both of which may be unlimited in their respective directions – that is potential unlimited gains for the buyer, as there’s no ceiling to how high the price of the underlying stock may rise – and unlimited loss for the seller if they need to purchase that stock in the open market to deliver it.
In other words, while the risk faced by a contract holder is limited to the premium paid to the seller, the writer’s risk can be substantial.Recall that as an option seller, you may receive a relatively small premium in exchange for acting as either buyer or seller to the holder of the option contract. If the contract owner proves correct and has locked in at a better price to buy or sell, it may cost you more as an option seller in the open market to fulfill your obligation to sell the required shares for that delivery, unless you already hold them.
If you’re an unhedged seller of a call option, you could feasibly face unlimited losses.
There are naturally several other advantages for traders to engage in the options market, as well as numerous additional risks that you may face. Given this, we urge you to conduct your own due diligence, depending on your financial conditions, investment objectives, or other requirements.
Disclosure: Interactive Brokers
The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.
Supporting documentation for any claims and statistical information will be provided upon request.
Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.
Disclosure: Options Trading
Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or click here. Multiple leg strategies, including spreads, will incur multiple commission charges.