Thursday, July 18th, 2019

Can You Lose Money Trading Options?

 

Warren Buffett has famously said that the first rule of investing is not to lose money and the second rule is not to forget the first! Does this apply to options as well? Can you lose money trading options? There are two answers: no and yes. How is that?

Limit Losses by Buying Options

Here are the basics. When you trade options you deal in puts and calls, either buying or selling. When you buy a call on a stock you are paying for the right to buy the stock at a fixed price no matter if the market price goes up. The full extent of your losses will be if the stock falls in price instead of going up. However, your loss will be the premium you paid for the call contract. If you buy a put on a stock you are purchasing the right to sell the stock at a set price no matter if it falls substantially. If the stock goes up in price you will obviously not exercise the contract but your losses will be limited to the premium you paid.

Virtually Unlimited Losses, or Not

When a trader sells calls or puts this is a different matter. A trader sells a call on a stock and receives a premium. If the stock goes up in price the purchaser does not lose any money but he goes not get to keep the now-more-valuable stock, providing that he already owned the stock (covered call option) But he does keep his premium. If he does not own the stock he needs to purchase at a higher market price and sell at the lower contract price thus losing money. When a trader sells a put on a stock he receives a premium for guaranteeing that he will buy the stock at the set contract price even if it falls to a lower market price. When the price of the stock falls he will lose money, quite possibly more money than he made with the premium.

In short when options trader buy calls or puts they limit their losses to the cost of the options contract. When options traders sell calls or puts they run the risk of huge losses if there is a large and unexpected change in stock price.

Where Are the Profits?

Interestingly, over the long run options sellers tend to make more money that options buyers. This is because the money they make on premiums typically is larger than what they lose on bad trades. The problem is that an options trader without sufficient reserves can be wiped out in a single bad trade. For this reason much of options selling is limited to large banks and traders with deep pockets.

Strategies

So, you can lose money trading options either by picking a few bad trades when you are selling or simply never picking a good trade when you are buying. How do traders in the real world deal with these risks? Professional options traders commonly use strategies that include both buying and selling either calls or puts. They are careful to pick trades that offer a better chance of winning than losing and they often use the premium from selling to pay the premium for buying. An example of this approach is called the long butterfly options strategy.

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