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Why Is Option Trading Risky? Get the Facts

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Written by Timothy Sykes
Updated 4/21/2023 8 min read

Option trading is risky because it’s hard to manage your risk! And risk is the top thing to pay attention to in trading.

When there’s more to learn, there are usually more chances to fail. I’ve seen many options traders blow their accounts up. They lose their initial investments… and sometimes so much more.

In this article, I’ll go over the reasons why options trading is risky. Trading without knowing the risks means you’re trading blindly — a big no-no.

Let’s dive in!

Why Is Options Trading Risky?

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Options trading is risky because it isn’t easy to cut your losses quickly.

What’s my Rule #1?

Some options trades, like long calls and covered puts, have built-in risk limiters. This means you only risk your premium to get the options contract. Other options trades have much higher potential losses. This usually happens in trades like naked puts.

So, what are the risks of options trading? Here are some of them:

  • You can lose your entire investment.
  • There’s potential for unlimited losses.
  • There’s no direct way to cut your losses quickly.

Higher options trading levels have higher-risk strategies. Check my guide to options trading levels to choose the one that’s right for you.

What Is Hedging in Options Trading?

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Hedging in options trading is a way to limit risk when one of your trades fails. This options strategy limits your losses by playing both sides of the chart.

Traders can hedge by trading competing options in competing sectors — for instance, getting options in a renewable energy stock AND an oil and gas stock.

They can also hedge by taking options in the same stock, ensuring they’re covered in the event of multiple outcomes.

Here’s an illustration of how a trader could use options to hedge:

Let’s say you buy 100 shares in XYZ Company for $14 each. You believe prices will rise, but you also buy 1 long-term put contract in the stock with a $10 strike price.

If XYZ Company stock prices rise as you expect, you can let your put option expire, only losing the premium you paid.

If XYZ Company stock prices drop to $6, you can exercise your put and sell your shares at $10 per share. That limits your losses to only $4 per share. Without the put option, you would have lost $8 per share.

Of course, you could limit your risk even more by cutting your losses quickly!

Spread option trading is a common strategy used in options trading. Learn more about spread option trading with my guide.

Why Do Stock Brokerage Houses Encourage Options Trading?

Stock brokerage houses encourage options trading because it’s one more way for them to make money. According to a 2021 Wall Street Journal article, brokers get paid more for options.

Brokers like Robinhood don’t allow short selling. Many traders have used covered put options as a substitute. And in the crazy trading environment of 2020 and 2021, many risky tactics paid off.

The trading culture that emerged online at the same time — in places like Twitter and the Reddit forum WallStreetBets — encouraged the home run swings that options offer. Traders were encouraged to post their losses and “bet” on improbable outcomes.

All of this contributed to the overheated options environment we have today. In 2020, Robinhood traders bought and sold options contracts at 88 times the rate of traders at Schwab, a more traditional broker.

Brokers like this because it’s good for business. I don’t like it — it’s a symptom of overtrading, one of the best ways to blow up your account.

Many internet-based trading platforms offer options trading, but which one is the best? Read my guides on the best options trading platforms and brokers.

Is Options Trading Riskier Than Trading Stocks?

Tim Sykes reviews his top penny stocks list for February 28, 2022
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Options trading is as risky as you let it be. The same goes for stock trading.

In 2022, an options-focused study called “Losing is Optional: Retail Option Trading and Earnings Announcement Volatility” was published by MIT and Stanford professors. The authors looked at options trading before 32,791 earnings announcements that took place between Jan. 1, 2010, and Feb. 28, 2021. They found that not only does activity spike before these volatile events, but that traders lost an average of 5–14% on these trades.

In 2002, a stock-focused study called “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” was published by UC Davis professors. It compared stock trading returns to the average market returns for 66,465 households with accounts at a large discount broker during 1991 to 1996, and found an average underperformance of 5.5% on their trades.

All forms of trading are risky. And most traders lose. You have to know that going in.

Build a trading plan that includes risk. Any strategy that has a chance of being successful has to include the possibility of losses. They will happen often.

Do you need to pay taxes on options trading? Read my guide to tax on options trading to find out.

Key Takeaways

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Options trading is risky, just like any other trading strategy. There’s always a chance you’ll lose money. What matters is managing risk, not completely avoiding it.

How can you manage risk? You need to build it into your trading plans.

Risk management is just one element of being a self-sufficient trader. Here are more key tips to becoming a smart trader:

  • Don’t copy other options trader’s picks. Their risk profile may be different, so what works for them may not work for you.
  • Learn options trading strategies from successful traders. Vet your mentors and make sure they provide accurate information.
  • Make your own stock watchlists. Research and list the stocks that might make good trades.
  • Record every options trade for future review. Improve on your strengths and your weaknesses.

Options trading is one of the hardest things you’ll ever learn. Luckily you can get a head start by learning to trade options from experienced traders.

In the options world, I think there’s no better mentor than my former student Mark Croock.

Mark has racked up $4 million in career earnings, mostly from trading options. He’s done this by adapting my penny stock trading strategies to options. He’s excellent with risk — he routinely trades options whose value has fallen below his risk, instead of holding them to the end like many options newbies.

Now he’s got his own mentorship program, called the Evolved Trader. Check it out for strategy sessions, trade alerts, a great chat room, and more!

How do you manage your risk in options trading? Let me know in the comments!

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Timothy Sykes

Tim Sykes is a penny stock trader and teacher who became a self-made millionaire by the age of 22 by trading $12,415 of bar mitzvah money. After becoming disenchanted with the hedge fund world, he established the Tim Sykes Trading Challenge to teach aspiring traders how to follow his trading strategies. He’s been featured in a variety of media outlets including CNN, Larry King, Steve Harvey, Forbes, Men’s Journal, and more. He’s also an active philanthropist and environmental activist, a co-founder of Karmagawa, and has donated millions of dollars to charity. Read More

* Results are not typical and will vary from person to person. Making money trading stocks takes time, dedication, and hard work. There are inherent risks involved with investing in the stock market, including the loss of your investment. Past performance in the market is not indicative of future results. Any investment is at your own risk. See Terms of Service here

The available research on day trading suggests that most active traders lose money. Fees and overtrading are major contributors to these losses.

A 2000 study called “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors” evaluated 66,465 U.S. households that held stocks from 1991 to 1996. The households that traded most averaged an 11.4% annual return during a period where the overall market gained 17.9%. These lower returns were attributed to overconfidence.

A 2014 paper (revised 2019) titled “Learning Fast or Slow?” analyzed the complete transaction history of the Taiwan Stock Exchange between 1992 and 2006. It looked at the ongoing performance of day traders in this sample, and found that 97% of day traders can expect to lose money from trading, and more than 90% of all day trading volume can be traced to investors who predictably lose money. Additionally, it tied the behavior of gamblers and drivers who get more speeding tickets to overtrading, and cited studies showing that legalized gambling has an inverse effect on trading volume.

A 2019 research study (revised 2020) called “Day Trading for a Living?” observed 19,646 Brazilian futures contract traders who started day trading from 2013 to 2015, and recorded two years of their trading activity. The study authors found that 97% of traders with more than 300 days actively trading lost money, and only 1.1% earned more than the Brazilian minimum wage ($16 USD per day). They hypothesized that the greater returns shown in previous studies did not differentiate between frequent day traders and those who traded rarely, and that more frequent trading activity decreases the chance of profitability.

These studies show the wide variance of the available data on day trading profitability. One thing that seems clear from the research is that most day traders lose money .

Millionaire Media 66 W Flagler St. Ste. 900 Miami, FL 33130 United States (888) 878-3621 This is for information purposes only as Millionaire Media LLC nor Timothy Sykes is registered as a securities broker-dealer or an investment adviser. No information herein is intended as securities brokerage, investment, tax, accounting or legal advice, as an offer or solicitation of an offer to sell or buy, or as an endorsement, recommendation or sponsorship of any company, security or fund. Millionaire Media LLC and Timothy Sykes cannot and does not assess, verify or guarantee the adequacy, accuracy or completeness of any information, the suitability or profitability of any particular investment, or the potential value of any investment or informational source. The reader bears responsibility for his/her own investment research and decisions, should seek the advice of a qualified securities professional before making any investment, and investigate and fully understand any and all risks before investing. Millionaire Media LLC and Timothy Sykes in no way warrants the solvency, financial condition, or investment advisability of any of the securities mentioned in communications or websites. In addition, Millionaire Media LLC and Timothy Sykes accepts no liability whatsoever for any direct or consequential loss arising from any use of this information. This information is not intended to be used as the sole basis of any investment decision, nor should it be construed as advice designed to meet the investment needs of any particular investor. Past performance is not necessarily indicative of future returns.

Citations for Disclaimer

Barber, Brad M. and Odean, Terrance, Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors. Available at SSRN: “Day Trading for a Living?”

Barber, Brad M. and Lee, Yi-Tsung and Liu, Yu-Jane and Odean, Terrance and Zhang, Ke, Learning Fast or Slow? (May 28, 2019). Forthcoming: Review of Asset Pricing Studies, Available at SSRN: “https://ssrn.com/abstract=2535636”

Chague, Fernando and De-Losso, Rodrigo and Giovannetti, Bruno, Day Trading for a Living? (June 11, 2020). Available at SSRN: “https://ssrn.com/abstract=3423101”