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Chapter 17 — Are There Risks to Options Trading?
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Are There Risks to Options Trading?

Are There Risks to Options Trading?

Options trading is recognized to be a high risk investment and even experienced trader may suffer significant losses. 

Risks to options trading compared to swimming with sharks

Speculation vs. Hedging 

One of the biggest advantages of trading options is that it gives you leverage with your money. This means that when you make a small investment, the potential returns from using options are higher than they would be from only trading the underlying asset. However, leverage works both ways, and your losses can be higher with leverage than they would be without leverage.

There are two basic reasons for trading options: Speculation, which increases risk , and Hedging, which reduces risk. For speculation, trading options is quite risky because you have to correctly predict the movement of a stock and when this movement will occur. Because of leverage, you can make a lot of money if you get it right, but you can also lose a lot of money if you get it wrong. Hedging is more of an insurance policy. It gives you the ability to protect against the downside of an investment .

For instance if you own a stock and you want to lock in the profits you have already made, you can buy an option to sell that stock at the current price. If the stock declines, you can still hold on to your gains by making the sale at the price set in your option contract. 

For example, if you bought $1,000 worth of call options based on Company X stock then you could expect much bigger profits. If the price of the stock rises, then you should directly invest that $1,000 into the stock. Bad news is if the stock decreased in value, or even just remained the same, your call options may turn up to be barren and you would lose your entire $1,000.  While having had bought stocks you would loose all your investments only in case of company's bankruptcy. 

 

Quiz

Which of the following is meant to reduce risk?

Correct
Incorrect
0/76 (0%) Correct
  • 1
    Leverage
  • 2
    Hedging
  • 3
    Speculation
  • 4
    Options Trading
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