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Why are call and put options considered risky?

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posted Jul 14 by Amrita

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1 Answer

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Option contracts are notoriously risky due to their complex nature, but knowing how options work can reduce the risk somewhat. There are two types of option contracts, call options and put options, each with essentially 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. Thus, knowing how each works helps determine the risk of an option position. In order of increasing risk, take a look at how each investor is exposed.

Long Call Option
Investor A purchases a call on a stock, giving him the right to buy it at the strike price before the expiry date. He only risks losing the premium he paid if he never exercises the option.

Covered Call
Investor B, who wrote a covered call to Investor A, takes on the risk of being "called out" of his long position in the stock, potentially losing out on upside gains.

Covered Put
Investor A purchases a put on a stock he currently has a long position in; potentially, he could lose the premium he paid to purchase the put if the option expires. He could also lose out on upside gains if he exercises and sells the stock.

Cash-Secured Put
Investor B, who wrote a cash-secured put to Investor A, risks the loss of his premium collected if Investor A exercises and risks the full cash deposit if the stock is "put to him."

Naked Put
Suppose Investor B instead sold Investor A naked put. Then, he might have to buy the stock, if assigned, at a price much higher than market value.

Naked Call
Suppose Investor B sold Investor A call option without an existing long position. This is the riskiest position for Investor B because if assigned, he must purchase the stock at market price to make delivery on the call. Since market price, theoretically, is infinite in the upward direction, Investor B's risk is unlimited.

answer Jul 15 by Anushka
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