Key Takeaways
● Buyers face a series of risks including loss of premium, loss of value of time, high volatility, liquidity risk, and delivery risk.
● Writers face a series of risks including loss of margin, significant loss, liquidity risk, and delivery risk.
Understanding
In options trading, the buyer pays a premium to buy an option. Meanwhile, the writer receives the premium and will be obliged to assume the corresponding obligation. The risks to buyers and writers are different as the rights and obligations to them vary.
The major risks to the buyer are:
Loss of premium. If an option contract held by the buyer is still out of the money by the expiration date, the buyer will lose all the premium.
Loss of time value. As long as an option has not expired, it has a time value.
With all other factors being equal, the time value of an option becomes worthless as the exercise date approaches.
High volatility. When the market price of an option deviates significantly from its theoretical value, but the investor still buys it at its market price, as its price returns to its intrinsic value, the investor will bear the loss therefrom.
Liquidity risk. For some significantly out-of-the-money and less liquid options contracts, the buyer might face the dilemma of trying to liquidate positions but is unable to find a counter-party.
Delivery risk. Buyers who hold in-the-money options at the exercise date shall exercise their options, which they need to pay the full amount of money or prepare the underlying assets, or will lose premium if not.
The major risks to option writers are:
Loss of margin. Option writers are required to pay margin when entering into short positions. When the underlying asset price fluctuates significantly, the writers might be forced to close a position if they fail to add margin in time.
Significant loss. When the underlying asset price moves against the option writer's expectation, the writer might face a significant loss.
Liquidity risk. if an option writer writes an option, the writer might be unable to buy underlying assets to make delivery in time or have to face a large bid/ask spread.
Delivery risk. When an in-the-money option contract expires, if the option writer receives the buyer's request to exercise the option, but is unable to prepare cash or underlying assets within the specified time, it will result in a delivery default and corresponding penalties.
