Option Selling Risks

When trading options, you have a lot to consider. Across all of the financial assets, equity options might be the most complex and nuanced of them all. This complexity shows up in the variety of risk factors which face option traders – so in this article we are going to break those down so you can ideally avoid them in the future.

Here are a few key takeaways we are going to learn about in this article:

  • Assignment Risk: American-style options can be exercised any time.
  • Ex-Dividend Risk: Short call holders face early assignment risk before ex-dividend dates if options are in the money.
  • Stop Hunting: Market players may manipulate prices to trigger stop-loss orders.
  • Liquidity Issues: Lack of a liquid market can prevent closing positions at desired prices.
  • Earnings/Event Impact: Earnings announcements can cause significant volatility.
  • Delta Risk: Changes in the underlying asset’s price directly impact options pricing.
  • After-Hours Trading: Movements after hours can lead to gap risk and unexpected assignment for short options.
  • Margin Calls: Falling below maintenance margin due to market moves can result in forced liquidation of positions at unfavorable prices.
  • Leverage Risks: Leverage in options can magnify both potential returns and losses.
  • Systemic vs Systematic Risk: The risk of the system, the market and the company.

Assignment Risk

Assignment risk in options trading is the possibility that an option holder exercises their option, compelling the option seller (or writer) to fulfill the terms of the contract. This risk is particularly significant for sellers of American-style options, which can be exercised at any time before expiration.

Traders selling covered calls face the risk of having to sell their underlying shares at the strike price, potentially missing out on further gains if the market price exceeds the strike price. Similarly, sellers of put options might be obligated to buy the underlying asset at a price higher than the current market value.

Assignment risk increases as the option goes deeper into the money and approaches expiration.

Here’s how it works:

  1. Exercise Notice Receipt: When an option holder decides to exercise their option, the clearing house receives an exercise notice.
  2. Random Pool Allocation: The clearing house then randomly selects a member firm that has an open short position in that particular option contract (strike price and expiration) to assign the exercise notice. This is where the “random pool” aspect comes into play. The selection process doesn’t specifically target individual accounts.
  3. Round Robin Within Firms: Once a member firm is selected, it internally allocates the assignment to one of its individual accounts holding the short positions according to its own policies.

This method ensures a degree of fairness and randomness in how assignments are distributed, reflecting the risks associated with writing options. For individual traders, this means that the assignment of exercised options can feel unpredictable.

It’s important for option writers to understand that while they cannot control if or when they will be assigned, they should always be prepared for the possibility, especially if they are holding short positions in in-the-money options as expiration approaches.

If you are short an option, and your option is In-The-Money you have assignment risk.

Managing this risk involves close monitoring of positions, understanding the dynamics of the underlying asset, and being prepared financially for the potential need to buy or sell the underlying asset at the contract’s terms.

Ex Dividend (Assignment Risk)

The term “ex-dividend” refers to a period in the trading cycle of stocks and certain other financial instruments during which a stock is traded without the right to receive the most recently declared dividend. When a company announces a dividend, it also specifies two important dates: the record date and the ex-dividend date.

  • Record Date: This is the date on which you must be on the company’s books as a shareholder to receive the dividend.
  • Ex-Dividend Date: This date is typically set one business day before the record date. To be eligible for the dividend, an investor must own the stock by the close of trading on the day before the ex-dividend date. If you buy the stock on its ex-dividend date or after, you will not receive the next dividend payment. Instead, the dividend will be paid to the seller.

On and after the ex-dividend date, the stock’s price is often adjusted downward by the amount of the declared dividend by the market. This adjustment reflects the fact that new buyers will not receive the dividend.

For short option holders, the ex-dividend date is crucial for a couple of reasons:

  1. Call Options: If you have sold call options (are short call options), there’s an increased risk of early assignment right before the stock goes ex-dividend, especially if the option is in the money (where the strike price is below the current market price of the stock). The holder of the call options may choose to exercise the option early in order to own the shares and thus qualify to receive the dividend. This is more likely if the dividend amount exceeds the remaining time value of the call option.
  2. Put Options: For short put options, the ex-dividend date might have a less direct impact, but it’s important to note that the stock price typically drops by the amount of the dividend on the ex-dividend date. This price drop can affect the intrinsic value of put options, making them more likely to be in the money (where the strike price is above the stock’s current market price), which could potentially increase the risk of assignment for the option seller.

In both scenarios, understanding the timing of dividends and how they interact with option prices and assignment risk is critical for traders. If you’re holding short options and approaching an ex-dividend date, it’s important to assess the risk of assignment and consider whether to close the position or take other actions to mitigate potential losses.

Stop Hunting

“Stop hunting” is a market theory where market makers or large traders attempt to manipulate or influence the market price temporarily to reach levels where they believe a significant number of stop-loss orders have been placed.

Say a stock is falling from 101 and is approaching 100. A trader might assume that people have stops at 100 or at 99 and will attempt to drive the price down to that level to trigger those stops.

When a large number of stop-loss orders are executed, it can create a rapid, short-term price movement, allowing the traders who initiated the stop hunting to benefit from this movement.

This strategy is often attributed to large institutional traders or market makers who have the capacity to make sizable trades that can impact market prices. By pushing the price to a level where stop-loss orders are triggered, these traders can buy at lower prices or sell at higher prices than would otherwise be possible if they were merely following the market’s natural flow.

In the context of options trading, particularly with short positions, stop hunting can lead to increased volatility around certain price levels, affecting the pricing and risk associated with holding or writing options. Traders and investors need to be aware of the possibility of stop hunting and consider it when placing stop-loss orders, choosing their order placements carefully to avoid being caught in such maneuvers.

Illiquid Markets (Inferior Pricing)

When you attempt to close your option position and discover there isn’t a liquid market to buy it back from you, several challenges arise, primarily due to the lack of buyers (or sellers) at your desired price point.

This liquidity component is often the most overlooked “risk” to options trading. It has a consistent yet obfuscated effect on your profitability that is hard to notice but important to track.

High liquidity means lots of trading activity, with small bid-ask spreads, making it easier to enter or exit positions at predictable prices. Conversely, low liquidity, characterized by wider bid-ask spreads and fewer market participants, can lead to several issues:

  1. Difficulty in Executing Trades: You may struggle to find a counterparty willing to take the opposite side of your trade at a reasonable price. This can result in your order not being filled at all, or only partially filled.
  2. Potential for Slippage: If you’re forced to adjust your price significantly to encourage a trade, the difference between the expected price of the trade and the executed price (slippage) can lead to less favorable prices, negatively impacting your overall profitability or increasing your losses.
  3. Increased Costs: To entice a buyer or seller in a low liquidity market, you might have to accept a wider bid-ask spread, which increases the cost of the trade. This directly affects how much you can make or lose on an option trade.
  4. Market Impact: In attempting to close a large position in a low liquidity environment, your trade itself could significantly impact the market price, potentially making it even harder to execute the trade without further reducing your returns. You are moving the market against yourself.
  5. Holding Until Expiration: In some cases, you might have no choice but to hold the option until expiration, facing the outcomes inherent to that choice, which could include exercising the option (if it’s in the money and you have the right to do so) or letting it expire worthless.

Navigating a low liquidity situation requires careful consideration of these factors and potential strategies to mitigate unwanted outcomes. It highlights the importance of liquidity as a key consideration when initiating an options position.

Earnings and Binary Events

Earnings events can significantly impact short option holders due to the potential for substantial price volatility in the underlying stock around the time of the earnings announcement. Here are some of the key ways earnings events can affect those holding short options positions:

1. Increased Volatility

  • Implied Volatility (IV) Surge: Leading up to an earnings announcement, the IV of options often increases due to the anticipated uncertainty and potential stock price movement the announcement might cause. This can inflate the premiums of options, affecting short positions unfavorably as it may increase the cost to buy back the option to close the position.
  • Post-Earnings IV Crush: After the earnings are announced, there’s typically a decrease in IV, known as an “IV crush,” which can benefit short option holders if they remain short through the announcement. The decrease in option premium post-announcement can make it cheaper to close out short positions profitably.

2. Directional Risk

  • Short option positions, especially uncovered (naked) calls or puts, carry significant directional risk. An unexpected earnings outcome can lead to drastic price movements that move the option deep in-the-money, exposing the holder to substantial losses.

3. Assignment Risk

  • For short options that become in-the-money around earnings, the risk of early assignment increases, particularly for American-style options that can be exercised at any time. If an option is assigned, the seller is obligated to fulfill the terms of the contract, potentially leading to significant financial implications.

4. Strategic Decisions

  • Short option holders might need to make strategic decisions ahead of earnings announcements, such as closing out positions to avoid volatility risks, rolling positions to different strikes or expirations to manage risk, or adjusting positions with additional trades to hedge against anticipated moves.

5. Potential for Larger Losses

  • Given the unpredictable nature of earnings outcomes and their potential to cause significant stock price movements, short option holders are exposed to the risk of larger than expected losses. This risk is especially acute for naked positions without an underlying asset or opposite option position to mitigate potential losses.

Risk of the Underlying Stocks Movement (Delta):

  • Idiosyncratic risk refers to the risk associated with a specific asset, such as a stock, which is independent of overall market risk. This type of risk is unique to a particular company or industry and can be caused by factors such as management decisions, regulatory changes, product recalls, or competitive pressures. Unlike systematic risk, which affects the entire market or a broad segment of it (like interest rate changes, economic recessions, or political instability), idiosyncratic risk can be mitigated through diversification. By holding a varied portfolio of assets, investors can reduce the impact of any single asset’s performance on their overall portfolio, as the risks associated with individual assets are unlikely to be correlated.
  • Systematic risk, also known as market risk or undiversifiable risk, affects the entire market or a broad segment of it. This type of risk is inherent to the entire market or market segment, resulting from factors such as economic recessions, political turmoil, changes in interest rates, natural disasters, and global pandemics. Unlike idiosyncratic risk, which can be mitigated through diversification across various assets or industries, systematic risk cannot be eliminated simply by diversifying a portfolio, as it impacts all investments to some degree.
  • Systemic risk refers to the potential for a breakdown or failure in the entire financial system or a substantial part of it, typically resulting from interlinkages and interdependencies in the financial markets that can lead to a cascading effect of failures. This risk is characterized by the possibility that the failure of a single entity or a group of entities can trigger a wide-reaching financial crisis, affecting financial institutions, markets, and economies globally. Systemic risk is often associated with events like the collapse of major banks or financial institutions, significant market disruptions, or economic downturns that can lead to widespread financial instability. Unlike systematic risk, which deals with market-wide risks affecting all investments, or idiosyncratic risk, which is specific to a single entity, systemic risk is about the collapse or significant impairment of the entire financial system.

After Hours:

Being short options after hours can expose traders to several risks, particularly because significant events or developments can occur outside regular trading hours. These events can lead to substantial price movements in the underlying asset when the markets reopen, impacting the value of the options positions. Here are key risks associated with holding short options positions after hours:

1. Gap Risk

Markets can open at significantly different levels from where they closed due to after-hours news or events (earnings announcements, geopolitical events, economic data releases). This gap in price can move against your position, potentially leading to significant losses, especially if you’re short options without a hedging strategy in place.

2. Limited Reaction Time

When significant news hits the market after hours, you have no immediate way to adjust or close your position until the market reopens. By then, the market’s move might have significantly impacted your position.

3. Liquidity Concerns

Even in extended-hours trading, liquidity is generally lower than during the regular session. This means even if some options markets are accessible after hours, wider spreads and less favorable conditions might make it difficult to manage your position effectively.

4. Assignment Risk

For American-style options, which can be exercised at any time, there’s a risk of assignment if the option goes in-the-money due to after-hours movements. You might find out you’ve been assigned on a short position, requiring you to fulfill the contract’s terms unexpectedly.

5. Volatility Surges

After-hours announcements can cause volatility surges that dramatically change the value of an options position. For short options, increased volatility generally means more significant risk and potential loss, as the price to buy back an option or the cost of assignment may skyrocket.

6. Margin Calls

If the after-hours movement against your position is significant enough, you might face margin calls or account liquidation if you’re unable to meet margin requirements. This scenario can force you into making rapid, potentially unfavorable decisions to cover the shortfall.

Integrating these concepts into your trading strategy requires a comprehensive approach to risk management, understanding market mechanics, and staying informed about events that could impact your positions. To put it all together in your trading:

  • Stay Informed: Keep up with relevant market news, especially earnings announcements and dividend dates, to anticipate volatility and manage positions accordingly.
  • Risk Management: Utilize stop-loss orders and consider diversifying your portfolio to mitigate idiosyncratic and systematic risks. Leverage should be used judiciously, with a clear understanding of its impact on potential gains and losses.
  • Understand Assignment Risks: Be especially cautious with short American-style options, which can be exercised at any time. Close or adjust positions before key dates like ex-dividend days to avoid unwanted assignments.
  • Monitor Liquidity: Trade options with high liquidity to ensure you can enter and exit positions with minimal slippage.
  • Prepare for After-Hours Moves: Be aware of the risks associated with holding positions after hours, particularly through earnings announcements or significant news events.

By incorporating these strategies:

  • You enhance your ability to navigate the complexities of options trading with a well-rounded perspective.
  • You can protect your portfolio from unexpected market movements and volatility, maximizing potential returns while minimizing risks.
  • Adapting to market conditions and adjusting strategies as necessary becomes a seamless part of your trading routine, contributing to long-term success.

This holistic approach empowers traders to make informed decisions, manage risks effectively, and capitalize on opportunities in the options market.