What Are The Benefits & Risks of Option Trading? (2024)

Open an account

Login

Open Menu bar

Most strategies used by options investors have limited risk but also limited profit potential. Options strategies are not get-rich-quick schemes and can also have unlimited loss potential.

Transactions generally require less capital than equivalent stock transactions. They may return smaller dollar figures but a potentially greater percentage of the investment than equivalent stock transactions.

Select to close help pop-upA short call option in which the seller (writer) does not own the shares of underlying stock represented by his or her options contracts or an offsetting long call options contract. If assigned, the seller is obligated to deliver the underlying security at the strike price. As the writer does not own the underlying security, the writer may have to purchase the underlying security at any price in order to meet the obligation. This represents unlimited risk as the underlying security has unlimited upward potential.

Although options may not be appropriate for all investors, they're among the most flexible of investment choices. Options can be used to apply a bullish, bearish or neutral strategy and utilized for generating income, hedging or speculation.

Reducing Your Risk

For many investors, options are useful tools of risk management. They act as a hedge against a drop in stock prices. For example, if an investor is concerned that the price of their shares in LMN Corporation are about to drop, they can purchase puts that give the right to sell the stock at the strike price, no matter how low the market price drops before expiration. At the cost of the option's premium, the investor has hedged themselves against losses below the strike price. This type of option practice is also known as hedging with a protective put.

While hedging with options may help manage risk, it's important to remember that all investments carry some risk. Returns are never guaranteed. Investors who use options to manage risk look for ways to limit potential loss. They may choose to purchase options, since loss is limited to the price paid for the premium. In return, they gain the right to buy or sell the underlying security at an acceptable price. They can also profit from a rise in the value of the option's premium, if they choose to sell it back to the market rather than exercise it. Since writers of options are sometimes forced into buying or selling stock at an unfavorable price, the risk associated with certain short positions may be higher.

Many options strategies are designed to minimize risk by hedging existing portfolios. While options act as safety nets, they're not risk free. Since transactions usually open and close in the short term, gains can be realized quickly. Losses can mount as quickly as gains. It's important to understand risks associated with holding, writing, and trading options before you include them in your investment portfolio.

Risking Your Principal

Like other securities including stocks, bonds and mutual funds, options carry no guarantees. Be aware that it's possible to lose the entire principal invested, and sometimes more.

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.

Since initial options investments usually require less capital than equivalent stock positions, your potential cash losses as an options investor are usually smaller than if you'd bought the underlying stock or sold the stock short. The exception to this general rule occurs when you use options to provide leverage. Percentage returns are often high, but percentage losses can be high as well.

Menu

Options involve risk and are not suitable for all investors. Certain requirements must be met to trade options. Before engaging in the purchase or sale of options, investors should understand the nature of and extent of their rights and obligations and be aware of the risks involved in investing with options. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options (PDF)" before considering any option transaction. You may also call the Investment Center at 877.653.4732 for a copy. A separate client agreement is needed. Multi-leg option orders are charged one base commission per order, plus a per-contract charge.

The maximum loss, gain and breakeven of any options strategy only remains as defined so long as the strategy contains all original positions. Trading, rolling, assignment, or exercise of any portion of the strategy will result in a new maximum loss, gain and breakeven calculation, which will be materially different from the calculation when the strategy remains intact with all of the contemplated legs or positions. This is applicable to all options strategies inclusive of long options, short options and spreads. To learn more about Merrill's uncovered option handling practices, view Naked Option Stress Analysis (NOSA) (PDF).

Early assignment risk is always present for option writers (specific to American-style options only). Early assignment risk may be amplified in the event a call writer is short an option during the period the underlying security has an ex-dividend date. This is referred to as dividend risk.

Long options are exercised and short options are assigned. Note that American-style options can be assigned/exercised at any time through the day of expiration without prior notice. Options can be assigned/exercised after market close on expiration day. View specific Merrill Option Exercise & Assignment Practices (PDF).

Supporting documentation for any claims, comparison, recommendations, statistics, or other technical data, will be supplied upon request.

View definitions for investment terms in our

Glossary.