Options has the potential for quick gains but it can also create disastrous losses. In the US, an option is a derivative or contract that allows someone to purchase or sell a stock at a specified price before an expiration date. Peter Lynch, a very successful mutual fund manager for Fidelity has never needed options. He cites several reasons to avoid them. The biggest risk for a call option, a contract to purchase stock, is that if the stock price does not rise, the option price trends towards zero each day and in the worse case, the option loses its entire value when option hits the expiration date but does not reach the strike price. There may be many unexpected events that can influence the stock price in the short term that no one can ever anticipate. Here are just a short list of examples of unexpected events:
- A company may announce that it’s product is delayed.
- Government agency may declare a company product is defective and need a recall.
- A company insider or asset manager may announce it is selling its stock.
- A country decides to invade another country and cause panic and inflation worldwide
- Company announces, due to supply chain issued beyond its control, it can only make 5 products instead of 1000.
- A company may announce it is acquiring another company and the price paid is considered too excessive by analysts.
Moreover, even if an event one predicted is correct, the broad public reaction to the event may not be what was expected.
Since there are so many ways things can go wrong, it is best to avoid the risk of trading options. If reading through all these potential risk factors, you still want to purchase options, do very careful analysis of the potential outcomes and only with money that you do not need or are willing to lose because the possibility of losing the entire amount is a very real possibility.
In contrast to buying options, if you own 100 or more of a stock, you can sell an option for each 100 shares and collect the some income. The risk you take on is a company may do really well or there is a sudden market irrational exuberance or enthusiasm and the stock prices soar past the strike price. You miss out on the gain above the strike price. During periods of stability, where price does not move, this is a viable strategy to make extra income without selling the underlying stock.