Saturday, August 24th, 2019

Counterparty Risk in Option Trading

November 26, 2009 by T.D. Thompson  
Filed under Options Trading Tips

 

Counterparty risk is an often-forgotten risk management matter in option trading. Counterparty risk is the risk that the seller of an option will not sell when the buyer chooses to exercise the option. You buy a put on IBM believing it will go down and it does, substantially. You exercise the option expecting to sell at a strike price and substantially above the spot price where you will buy. It is payday! Thoughts of trips around the world sail through your head. Then, oops, the reason IBM is down is that the market is crashing and the seller of your put does not have the money to buy your stock! How does your risk management strategy avoid this situation?

Working through a strong intermediary helps avoid counterparty risk in option trading. The intermediary charges a fee for their service and protects their own position with hedging and having a substantial asset base. Nevertheless, in the market collapse even the smartest and most substantial intermediary can be overwhelmed.

In option trading on stocks risk management is handled by trading through standardized options contracts listed on futures and options exchanges. These markets provide accurate, up to date information, and back all contracts. Exchanges typically have AAA credit ratings and on exchanges counterparties remain anonymous.

The standard risk in option trading stems from market uncertainty. You buy a call on a stock and it goes up. You can exercise the option, buy the stock at the strike price and own the stock at the now-higher spot price. You sell the stock, pay commissions, deduct the premium you paid, and count your profits. Then again, as you are waiting for the stock to go up it crashes. You are out the commission and have lost the chance of earning a large profit. What is your risk management here? The answer is to sell the option and not wait to exercise it. In option trading the value of the option reflects what you would earn if you exercised the option.

If you are buying puts or calls in options trading you always have the option of trading away your option, hopefully, for a profit. That is why they call it option trading. The option you hold on 100 shares of stock can be sold to the next option trader which gets you out of the option and solves the risk problem whether it is a counterparty risk or the risk of market fluctuation.

Hedging is also option trading risk management strategy. On the other hand option trading is often a risk management strategy for those who own stock. Owners of stock in a very fluid market may choose to buy a put option on their stock so that if they stock drops substantially they can exercise the put and sell at the strike price and not the now-lower spot price. They already have the stock.

On the other hand, with a long straddle you buy both a call option and a put option on the same stock at the same strike price with the same expiration date. In this option trading strategy your risk management is that you can only lose the premiums you pay if the stock does not change price. If the stock goes up or down substantially you will exercise the appropriate option and make a nice profit.

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