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
The risk of buying both call and put options is that they expire worthless because the stock doesn't reach the breakeven point. In that case, you lose the amount you paid for the premium. It's also possible to sell call and put options, which means another party would pay you a premium for an options contract.
Why are puts and calls risky? ›
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.
What are the risks of a call option? ›
The risk of buying the call options in our example, as opposed to simply buying the stock, is that you could lose the $300 you paid for the call options. If the stock decreased in value and you were not able to exercise the call options to buy the stock, you would obviously not own the shares as you wanted to.
What is the riskiest option strategy? ›
Selling call options on a stock that is not owned is the riskiest option strategy. This is also known as writing a naked call and selling an uncovered call.
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.
How do you explain call and puts? ›
A call option is in the money (ITM) if the underlying asset's price is above the strike price. A put option is ITM if the underlying asset's price is below the strike price. For calls, it's any strike lower than the price of the underlying asset. For puts, it's any strike that's higher.
What are call options and puts for dummies? ›
Buying a put option is best if you believe the underlying asset is going down in price. What Are Puts and Calls for Dummies? Call options are purchased when the buyer believes the underlying asset is price will rise. Put options are purchased when the buyer believes that the underlying asset is price will decrease.
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 option buyers lose money? ›
As options approach their expiration date, they lose value due to time decay (theta). The closer an option is to expiration, the faster its time value erodes. If the underlying asset's price doesn't move in the desired direction quickly enough, options buyers can suffer losses as the time value diminishes.
Are call options risk free? ›
Remember, the call is "covered" if you sell shares you already own but, if it's "uncovered," you must find shares to sell to the call purchaser. Options trading entails significant risk and is not appropriate for all investors. Certain complex options strategies carry additional risk.
The option sellers stand a greater risk of losses when there is heavy movement in the market. So, if you have sold options, then always try to hedge your position to avoid such losses. For example, if you have sold at the money calls/puts, then try to buy far out of the money calls/puts to hedge your position.
What is the safest put option? ›
Selling cash-secured puts is considered the safest strategy because it has defined risk and income potential. The maximum possible loss is capped at keeping the cash deposited until expiration.
What is the safest type of trading? ›
Among the different types of trade, long-term trading is the safest strategy. It suits most conservative investors who do not mind buying and holding stocks for years.
What are the risks of call options? ›
As an options holder, you risk the entire amount of the premium you pay. But as an options writer, you take on a much higher level of risk. For example, if you write an uncovered call, you face unlimited potential loss, since there is no cap on how high a stock price can rise.
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.
Is selling puts or calls more risky? ›
While call options give the holder the right to buy shares, put options provide the right to sell shares. With call options, the seller will have unlimited risk while the option seller in put options has limited risk. The buyer in call options has limited risk. An options buyer in put options has limited risk.
Why is selling calls risky? ›
Selling uncovered calls.
This strategy is considered very high risk, as you're theoretically exposed to unlimited losses. That's because there's really no limit to how high a stock can rise.
Is it smart to buy calls and puts? ›
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.
What are the disadvantages of selling put options? ›
The disadvantage of selling a put is that the profit potential is limited. If the stock price rises sharply, then the short put profits only to the extent of the premium received.
