This section deals with the special risks associated with traded stock options. More generic risks associated with dealing in securities in general are not covered here.
There is a wide range of option strategies available. The first thing investors should note is that some strategies may be suitable for them and some others may not. Investors should be selective in making their strategy decisions and think through the consequences before entering into any particular strategy, asking themselves the question: “What is the worst theoretical loss I might sustain? Can I afford to lose that much?”
It is commonly said that, for option holders, the risk is always limited while the risk for option writers can be unlimited. While this may be correct, the nature of risk in options trading should not be viewed simply in terms of “limited” versus “unlimited” risk. Buying options can lead to greater losses than writing them, and vice versa.
It is helpful to distinguish between the types of risks faced by option holders and option writers.The only way an option holder can avoid losing the entire premium is to close out the long position before expiry or to exercise the option before or at expiry. Unlike stocks, there is a limited time period in which to operate. It is therefore important to note the time frame in which the option might possibly become profitable.
Of course, if the purpose of the option was to hedge an underlying stock position, this loss of premium may be something that is acceptable from the outset, being effectively the cost of insurance.
2. The closer an out-of-the-money option is to expiry, the greater the likelihood that it will be impossible to close out or exercise profitably.
Time is not on the side of the option holder. This is particularly the case with out-of-the-money options which might sometimes be tempting to buy because they look “cheap”. Investors should accept the strong possibility that they may lose the entire premium paid. Many options might appear to be cheap for the good reason that they are actually very unlikely ever to become profitable. It is particularly important to be cautious if a large number of options are purchased in the hope of a leveraged profit.
3. Stock options in Hong Kong are not always automatically exercised on expiry.In order to realise any profits from a long option position prior to or on the last trading day, it is necessary to instruct your broker to exercise or close out the option before or on the last trading day.
SEOCH does automatically exercise certain deep in-themoney options upon expiry, but your broker is able to override this automatic exercise function.
Your broker may not be under an obligation to inform you that an option is about to expire. If you forget to exercise and your broker does not alert you, you may forgo all the profit that would otherwise have been realised.
4. If you exercise an option which is not hedged in the stock market you must be prepared to pay for the full value of the stock under the terms of the option contract (in the case of a call option) or to deliver stock (in the case of a put option).
Unless you already have made arrangements to sell the stock immediately on receipt (in the case of a call option) or already hold the stock (in the case of a put option), you must ensure that you have the funds to meet your delivery obligations.
It may happen that you are unable to close an in-the-money option position before the expiry date and therefore the only way of taking profits is by exercising. If you have entered into a highly leveraged position, it is possible that the quantity of stock to be transacted on exercise is greater than you would ever have intended to trade, which may have extremely serious consequences for your ability to complete the transaction and may result in significant losses.
5. Your broker may have the right to refuse to accept your exercise instruction.In the previous example, your broker may demand that you deliver sufficient financial resources to make settlement in respect of an option position and may therefore refuse your exercise instruction until you have made the necessary payment. The result could be that you lose money or forgo profits.
6. You may be required to pay margin on an exercised option position.Even if you are an option holder and therefore have not needed previously to pay margin on the long position, the margining system of the Clearing House can require margin to be paid on pending stock positions after exercise. This may happen if the underlying share price moves sufficiently following the exercise of the option so that the strike price is no longer in-the-money or is less deeply in-the-money than when it was exercised. This is different from the stock market where, ordinarily, one does not expect to pay margin prior to settling the stock transaction.
If a writer’s call option is uncovered (i.e. the writer does not already hold the stock), this will require that the writer urgently obtain the stock either by buying it in the open market or borrowing it. In either case, the difference between the price at which the stock is acquired and the strike price of the assigned option may be substantial and will represent an outright loss. Of course if the stock is borrowed, the possibility exists of further losses.
The losses incurred may be greatly disproportionate to the premium income received from the writing of the call option.
8. The writers of put options are required to take delivery of and pay for stock on being assigned.
The writer of a put option, on being assigned, will be required to buy the stock at the strike price of that option. The writer may therefore be required to pay substantially more than the current market price for the stock, thus incurring significant losses, which may be greatly disproportionate to the income received when the put option was written.
9. Stock options are American style. Call writers and put writers may be assigned at any time.
Although it is generally more profitable to sell an option than to exercise it early, there are exceptions where option holders will exercise early. This can happen particularly around the time of a stock going ex-dividend or when liquidity in an inthe-money option series is such that holders find it difficult to sell their options for more than intrinsic value.
Writers must be constantly aware of the possibility of early exercise, and the funding that may be required to meet the delivery and settlement obligations, which will generally be significantly greater than the option’s premium value.
10. All short option positions are subject to sudden increases in margin requirements.The leveraged nature of options means that option values and hence margin requirements can increase dramatically over a very short period. Your broker is entitled to close out your position, and seize any other collateral to which he is legally entitled in the event that you are unable to meet the margin call.
11. Covered call writers lose the right to any upside in the stock price but remain exposed to losses in the event the stock price falls.
A covered call writer will not be exposed to losses in respect of the call option itself. The stock covers any risk of being assigned. However, the nature of this risk is that the writer cannot benefit from any upside for as long as the short call option position is open. Moreover, if the stock price falls, the writer will suffer losses offset only by the value of the premium received when the option was first written.
LEVERAGEMost of the risk described above arises from the leveraged nature of options. The greatest danger of incurring serious losses lies in using leverage — trading in greater quantities of stock options than one would be willing to trade in the underlying stock itself.
A rule of thumb that could be followed by risk-averse options investors would be to avoid excessive leverage.If your options strategy is to use the options market to express a view that you would otherwise have expressed in the stock market, then the least risky way to do this is to trade in the equivalent underlying quantity as if you were trading in the stock market itself.
For many reasons, an option series can become illiquid. If it does, it may become impossible to liquidate an open position and thus unexpected losses could be faced. Profits that had been anticipated may be impossible to realise if you cannot trade the option itself.
For example:a) Trading in a particular underlying stock may be suspended or the whole market may be suspended (e.g. during a typhoon). In this case, all options on that stock will almost certainly be suspended at the same time. If the suspension continues over an expiry date, it may be necessary to deem the options to be cash settled.
b) Even in a less drastic situation where the option is not suspended, illiquidity may still occur. The option may still be trading but become illiquid through simple lack of investor interest. The implied volatility levels at which an option trades may quickly become so high or so low that even with a relatively stable share price, option prices fluctuate significantly. Your view of the “theoretical price” may not match the actual trading price. Sometimes an option may even trade at less than its intrinsic value.
c) Although the stock options market has a Market Maker system, there are a limited number of Market Makers and it is possible that a situation could arise where a Market Maker is not available or fails to meet its obligations.
d) It is possible that in very unusual circumstances a restriction could be placed on the opening of any new positions in a particular option class if the Clearing House felt this was in the best interests of the market. This may hinder one’s ability to liquidate or hedge open positions.
Although the option may be difficult to trade in such circumstances, holders of in-the-money options can at least exercise and try to realise their profits that way. But it is worth repeating item 4 above that exercising the option may present problems of its own.
13. Stop loss orders may be ineffective. They may be harder to execute with stock options than with other exchange-traded products.
For the reasons noted above and because of the inherent volatility of option prices, it is important not to place too much reliance on the successful execution of stop-loss orders, if the failure of the stop-loss order to be executed would lead to your options exposure increasing to unmanageable levels.
14. Spread trades designed to limit risk may not always be as effective as intended.Although spreads are attractive as a means of limiting options exposure, there are potential pitfalls. If one leg is assigned without there being an opportunity to exercise or liquidate the other, this can create delivery and settlement problems.
Or it may happen that it is difficult to close out both legs at the same time; if, for example, just the long leg is closed, the short will be left unhedged.
Moreover, the bid and offer spreads prevailing at the time the spread was entered into may be less favourable by the time you want to liquidate and so the strategy may be less effective than you had expected.
Finally, the dealing costs associated with trading options may make impractical a spread strategy that looks attractive in the textbook. Many strategies are not effective when the investor is paying all the dealing costs at the full rate or is only able to buy at the best offer and sell at the best bid.
15. Short straddles and strangles (i.e. the simultaneous writing of both puts and calls on the same underlying stock) may be difficult to liquidate, leaving the writer with excessive exposure.
If a straddle is to work well, it is often desirable to liquidate both positions at the same time. In a very volatile market and where it is difficult to liquidate the position, it is feasible that you could be assigned on both legs on separate occasions not only incurring significant trading losses but also creating large, unexpected and problematic settlement positions in the underlying stock.
16. When you trade options you are in a principal to principal contractual relationship with your broker which may leave you exposed in the event of the broker defaulting.
As with all dealing in securities there are risks associated with broker default. But when you have open option positions, the contractual relationship remains open throughout the option’s life. In the event of a broker defaulting, the assets and open positions of clients, despite requirements that they be segregated from the broker’s own assets and open positions, may be frozen or be otherwise inaccessible as a result of the default procedures. This may happen for a long enough period to prevent those positions from being liquidated and losses or forgone profit opportunities may then arise.
In the event of default by a broker which results in pecuniary loss to its client, the client has a right to claim under the Compensation Fund established under the Securities Ordinance, subject to the terms of the Compensation Fund from time to time. An Options Broker Exchange Participant who enters into transactions with clients, and effects matching transactions with an Options Trading Exchange Participant, will not have a right to claim under the Compensation Fund in respect of any default of the Options Trading Exchange Participant.
17. Options exposure continues over time. Events may occur which need your immediate attention.
It is extremely important that you remain accessible to your broker while you have an open option position - particularly a short option position. Given the need for rapid action in the event, for example, of a margin call being made or a position being assigned, your broker may need your instructions at very short notice, otherwise he may be required to liquidate your positions and seize your collateral, giving rise to potentially large losses.
If you are likely to be out of contact, appropriate arrangements should be put in place such as pledging adequate collateral, leaving practical and executable instructions in relation to the open positions or closing out open positions.
18. Changes to option strike prices and contract sizes that arise from capital adjustments may be disadvantageous to the holders or writers of those options.
In most conventional capital adjustment cases, it is a relatively straightforward matter to ensure that the change to the options contract terms is fair. But there may be occasions when there is an extremely complex change to the capital structure of an underlying share that makes it impossible to render an adjustment that is perceived as fair by all participants. Such events are extremely rare in Hong Kong but they may occur.
It should also be noted that after adjustment, the adjusted series can sometimes become less liquid than before the adjustment.