Options trading is a trading process offering investors the opportunity to earn significant gains, but it also carries the risk of quick losses if you’re not careful. That’s why understanding the common reasons behind losses is key to getting through this complex financial process more effectively. In this blog, we will discuss the meaning of options trading, its types and the seven top reasons why you might be losing in options trading.
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What is Options Trading and What are its Types?
Options trading is a financial practice where investors can buy or sell the right to purchase or sell an underlying asset at a predetermined price on a future date. This system functions on the premise that the buyer holds the choice to execute the contract but bears no obligation to do so. It offers participants flexibility in managing their investments, allowing them to speculate on price movements without the necessity of outright ownership of the asset.
Options trading allows investors to buy or sell the right to purchase or sell an asset at a set price in the future. Call & put options are the two primary kinds.
- Call Options
Call options allow buyers, and do not come with an obligation to buy any asset at a fixed price before or on the expiry date. Usually, investors use this option when they see the price of the asset rise.
Two kinds of call options:
- Long Call Option: Buyers have the right to purchase the asset.
- Short Call Option: Sellers are obliged to sell the asset if the buyer exercises the option.
- Put Options
Put options provide traders access but not the obligation, to sell an asset at a set price before or on the expiry date. This option is mostly used when the prices are expected to fall.
Two kinds of put options:
- Long Put Option: Buyers own the right to sell the asset.
- Short Put Option: Sellers are supposed to buy, if sellers want to sell.
- Options Based on Underlying Security
- Stock Options: Based on shares of a listed company.
- Index Options: Based on stock market indices.
- Currency Options: Based on currency pairs.
- Futures Options: Based on futures contracts.
- Commodity Options: Based on physical commodities or futures contracts.
7 Key Reasons for Option Buyers’ Losses
Options trading methods can be used for different uses, including hedging against potential losses or capitalising on market opportunities. It is about understanding market fluctuations, risk assessment, and strategic decision-making. Investors must understand the intricacies of options and other risks that are involved in the trading. Here are some of the reasons behind loss-making in options trading.
- Lack of Asset Understanding
Many option traders face losses because they don’t fully understand the unique features of the assets which they are trading. Jumping from trading one type of asset to another without recognising their differences can lead to unexpected results. For instance, option trading strategies that work well for trading index options might not yield the same outcomes when applied to individual stock options due to variations in volatility and trading patterns.
- Attraction to Inexpensive Options
Some traders are attracted to cheap options because of their low premiums. They may buy these contracts without fully considering the associated risks. While inexpensive options offer the potential for high returns, they’re also more likely to fail to profit from price movements within the desired timeframe. This can result in reduced profits or even losses.
- Trading Illiquid Options
Trading illiquid options or stocks presents another challenge for option buyers. Limited liquidity makes it difficult to find favourable deals and makes it harder to exit trades when needed. This lack of liquidity can leave traders stuck in unfavourable positions, unable to efficiently close their trades.
- Selection of Deep Out of the Money (OTM) Options
Some buyers are drawn to options that are significantly out of money because of their low premiums. However, they often overlook the low probability of these options becoming profitable. As a result, they may end up holding difficult options, with the value of these options being entirely dependent on time.
- Exposure to Significant Events
Holding options through important events like earnings reports can lead to losses if the outcomes of these events disappoint. In such cases, the value of the options may fall, resulting in significant losses for the buyer.
- Overly Bullish Trading Strategies
Being overly bullish on moderately bullish views can lead to losses. Choosing strategies like bull call spreads over call options can help reduce overall costs and minimise the risk of significant losses.
- Inherent Nature of Options as Hedging Instruments
Options are similar to insurance policies in a way that they’re meant to hedge downside risks. However, it’s typically the sellers who profit from options, not the buyers. This poses a challenge for option buyers to consistently make profits, as they often find themselves at a loss compared to sellers.
Conclusion
While options trading holds the promise of significant returns within a short timeframe, many traders struggle to capitalise on these opportunities and instead face losses. Understanding the specifics of options trading is important before engaging in such activities. Common pitfalls include the ones we’ve discussed above. However, you can recognise and address these challenges, to enhance your chances of success in the fluctuations of options trading.
