John Lansing

Know Your Enemies

by John Lansing   10/01/08

When you buy and sell options on the options market, there are a number of inherent risks, and you should have a firm understanding of them before you invest in options.

Time

If you are an option buyer, time is your enemy.

The time factor is the major difference between purchasing stock and purchasing options. Whereas time can be your friend in a stock purchase, it is your enemy when you purchase an option.

All options have an expiration date, and as soon as you buy an option its value immediately begins to deteriorate. It should be noted that the time-loss value increases as the option gets closer to expiration.

When purchasing an option, you must not only be right about the direction that the underlying stock will go, but you must also be right about when this move will happen.

A mistake in the timing -- even if you're only off by a couple of days, could cost you.

All or Nothing

One unusual feature of the options market is its all-or-nothing perspective.

If the underlying stock moves in the opposite direction you anticipated, the option's value can rapidly decrease. In fact, traders are often caught off-guard by how fast options can lose their value.

The rapid loss is due not only to the decreasing stock value, but is compounded by the loss of value due to time deterioration. The greater the movement of the stock in the wrong direction, the less likely it is to recover in the time remaining in the life of the option.

Of course, on the other hand, if you made the right call concerning the stock's direction, it's easy to see your investment quickly double.