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>>> CHAPTER X - PRINCIPAL RISKS OF OPTIONS POSITIONS
This chapter discusses the principal risks of holders and writers of options. The risks discussed are those that are unique to being an option holder or writer. Risks that relate to such matters as the trading of securities generally; the state of the economy; the supply and demand factors in the options markets and in other related markets; the factors affecting the values of the various underlying interests; the factors affecting the volatility, liquidity and efficiency of the options markets or of other markets or other factors that may affect the pricing of particular options; the quality or operations of the various options markets at any particular time; and the procedures of the various options markets and of brokers in transmitting orders and effecting executions are not within the scope of this booklet and are not discussed. (See the discussion in Chapter XI as to the scope and limitations of this booklet.)
It should also be noted that new types of options and new options strategies are constantly being developed and that some of the risks of new options products and new options strategies do not become apparent until there has been significant experience in trading and using the new options and strategies. Accordingly, readers should be aware that there is a risk in newness, particularly if the new option or strategy is complicated or complex, that cannot always be identified or described.
Readers should also be aware that not all options strategies will necessarily be suitable for them and that certain strategies may expose them to very significant potential losses. For example, the risks associated with the writing of puts or uncovered calls expose investors to such potential losses, and this type of strategy is therefore not suitable for all investors.
Many of the risks are the same for options on all types of underlying interests, although some special risks may apply only to options on particular types of underlying interests. The first three sections of this chapter describe risks that apply generally to options on all types of underlying interests. They are followed by sections discussing the special risks associated with options on the particular types of underlying interests.
RISKS OF OPTION HOLDERS
1. An option holder runs the risk of losing the entire amount paid for the option in a relatively short period of time. This risk reflects the nature of an option as a wasting asset which becomes worthless when it expires. An option holder who neither sells his option in the secondary market nor exercises it prior to its expiration will necessarily lose his entire investment in the option. (As noted in Chapter VIII, many brokerage firms have procedures for the exercise of options at expiration that are then in the money by a specified amount.)
The fact that options become valueless upon expiration means that an option holder must not only be right about the direction of an anticipated price change in the underlying interest, but he must also be right about when the price change will occur. If the price of the underlying interest does not change in the anticipated direction before the option expires to an extent sufficient to cover the cost of the option, the investor may lose all or a significant part of his investment in the option. This contrasts with an investor who purchases the underlying interest directly and may continue to hold his investment, notwithstanding its failure to change in price as anticipated, in the hope of waiting out an adverse price move and eventually realizing a profit.
The significance of this risk to an option holder depends in large part upon the extent to which he utilizes the leverage of options to control a larger quantity of the underlying interest than he could have purchased directly with the same investment amount. This is illustrated in the following example, which compares the consequences of three different approaches to investing the same amount of money in stock or options, with each approach involving a different degree of leverage.
EXAMPLE: Assume that Investors A, B and C each have $5,000 to invest and that each anticipates an increase in the market price of XYZ stock, which is currently $50 a share. Investor A invests his $5,000 in 100 shares of XYZ. Investor B invests $500 in the purchase of an XYZ 50 call (covering 100 shares of XYZ at a premium of $5 a share) and invests the remaining $4,500 in a relatively risk free investment such as Treasury bills. (For purposes of this example, it is assumed that all of the calls are purchased when they have six months remaining until expiration, and that the risk free investment bears interest at an annual rate of, say, 3.25% - which means that a $4,500 investment will earn approximately $73 in interest over six months.) Investor C invests his entire $5,000 in 10 XYZ 50 calls.
If each option is held for six months and, if it is profitable, is either sold or exercised immediately before it expires, the following table illustrates the dollar and percentage profit or loss that each investor would realize on his $5,000 investment, depending upon the price of XYZ stock when the option expires.
Price of XYZ Stock at Exp.of Option Investor A Investor B Investor C
Profit or Loss % Return Profit or Loss % Return Profit or Loss % Return
62 1,200 24% 773 15.50% 7,000 140%
58 800 16% 373 7.50% 3,000 60%
54 400 8% -27 -0.50% -1,000 -20%
50 0 0 -427 -8.50% -5,000 -100%
48 -400 -8% -427 -8.50% -5,000 -100%
42 -800 -16% -427 -8.50% -5,000 -100%
38 -1,200 -24% -427 -8.50% -5,000 -100%
The table demonstrates how increased leverage results in greater profit potential on the upside and greater risk of loss on the downside. Investor C, as the most leveraged investor, would realize the highest percentage return if the price of XYZ increased to 62, but would incur a 20% loss even if the price of XYZ increased to 54 (assuming he did not sell his options while they had significant remaining time value), and would lose all of his investment if the price of XYZ stayed at or below 50.
2. The more an option is out of the money and the shorter the remaining time to expiration, the greater the risk that an option holder will lose all or part of his investment in the option. The greater the price movement of the underlying interest necessary for the option to become profitable (that is, the more the option is out of the money when purchased and the greater the cost of the option) and the shorter the time within which this price movement must occur, the greater the likelihood that the option holder will realize a loss. This does not necessarily mean that an option must be worthwhile to exercise in order for a holder to realize a profit. Instead, it may be possible for the holder to realize a profit by selling an option prior to its expiration for more than its original cost even though the option never becomes worthwhile to exercise. (The shorter the time remaining until expiration the less likely it is that this will be possible.)
3. Prior to the period when a European-style option or a capped option is exercisable, the only means through which the holder can realize value from the option (unless the capped option is automatically exercised) is to sell it at its then market price in an available secondary market. If a secondary market for such an option is not available during the time the option is not exercisable, it will not be possible for its holder to realize any value from the option at that time.
4. The exercise provisions of an option may create certain risks for the option holders. If the option does not have an automatic feature, a holder who wishes to exercise must assure that action is taken in a timely manner. See the discussion of "How to Exercise" in Chapter VIII.
On the other hand, if the option has an automatic exercise feature-such as one that will cause the option to be automatically exercised at the expiration if it is in the money by a specified amount- the option may be exercised at a price at which the holder would not voluntarily choose to exercise in view of the transactions costs of exercise or other factors. The transaction costs associated with the exercise could even exceed the cash settlement amount of the option, with the result that the holder would realize a net loss from the exercise. Conversely, an option that has a cash settlement amount that is less than the threshold amount cannot be exercised even though the option holder's transaction costs may be low enough to permit the option to be exercised profitably. In such a case, the option may expire unexercised.
The automatic exercise feature of capped options imposes a maximum value that a holder of these options can receive. Even if the option holder expects the value of the underlying interest to continue to move in a favorable direction prior to its expiration, the automatic exercise feature will prevent the holder from realizing any gain from the option in excess of the cap interval times the multiplier for the option.
5. The courts, the SEC, another regulatory agency, OCC or the options markets may impose exercise restrictions. While an American-style option can normally be exercised at any time prior to its expiration, OCC and the options markets have authority to restrict the exercise of options at certain times in specified circumstances. The options markets often exercise such authority with respect to an option in which trading has been halted. If a restriction on exercise is imposed at a time when trading in the option has also been halted, holders of that option will be locked into their positions until either the exercise restriction or the trading halt has been lifted.
Exercise restrictions imposed by OCC and the options markets affecting cash-settled options generally cannot be continued in effect beyond the opening of business on the last trading day before their expiration. Such exercise restrictions affecting physical delivery options generally cannot be continued beyond the opening of business on the tenth business day before their expiration, but with one important exception. If OCC determines that the available supply of a security underlying a physical delivery option appears to be insufficient to permit delivery of the security by the writers of all outstanding calls in the event of exercise, or that foreign government restrictions would prevent or unduly burden the orderly settlement of exercises of foreign currency options, OCC may indefinitely prohibit the exercise of puts by holders who would be unable to deliver the underlying security. The holder of such a put could lose his entire investment in the option if the prohibition remained in effect until the put's expiration and the holder was unable either to acquire the underlying interest or to sell his put in the market. The put holder might be unable to do either because the very event that caused OCC to impose the exercise prohibition-e.g., a suspension of trading in an underlying stock-might not only make it difficult or impossible to obtain the underlying interest, but might also impair the market in options on that interest.
It is also possible that a court, the SEC or another regulatory agency having jurisdiction would impose a restriction which would have the effect of restricting the exercise of an option. In such a case the option would not be exercisable until the restriction was terminated. In the remote possibility that the restriction were to remain in effect until the expiration of the option-which has never yet occurred-the option would expire worthless, and the holder would lose the entire amount that he paid for the option.
RISKS OF OPTION WRITERS
1. An option writer may be assigned an exercise at any time during the period the option is exercisable. Starting with the day it is purchased, an American-style option is subject to being exercised by the option holder at any time until the option expires. This means that the option writer is subject to being assigned an exercise at any time after he has written the option until the option expires or until he has closed out his position in a closing transaction. By contrast, the writer of a European-style or capped option is subject to assignment only when the option is exercisable or; in the case of a capped option, when the automatic exercise value of the underlying interest hits the cap price.
An assigned writer may not receive notice of the assignment until one or more days after the assignment has been made by OCC. Once an exercise has been assigned to a writer, the writer may no longer close out the assigned position in a closing purchase transaction, whether or not he has received notice of the assignment. In that circumstance, an attempted closing purchase would be treated as an opening purchase transaction.
If an option that is exercisable is in the money, the option writer can anticipate that the option will be exercised, especially as expiration approaches. Once he is assigned an exercise, the assigned writer must deliver (in the case of a call) or purchase (in the case of a put) the underlying interest (or pay the cash settlement amount in the case of an in the money cash-settled option). The consequences of being assigned an exercise depend upon whether the writer of a call is covered or uncovered, as discussed below.
2. The writer of a covered call forgoes the opportunity to benefit from an increase in the value of the underlying interest above the option price, but continues to bear the risk of a decline in the value of the underlying interest. Unlike a holder of the underlying interest who has not written a call against it, the covered call writer has (in exchange for the premium) given up the opportunity to profit from an increase in the value of the underlying interest above the exercise price. If he is assigned an exercise, the net proceeds that he realizes from the sale of the underlying interest pursuant to the exercise could be substantially below its prevailing market price.
EXAMPLE: When XYZ stock was $50, the investor collected a $4 a share premium by writing an XYZ 50 delivery call. As expiration approaches, the stock has risen to $58 and he is assigned an exercise. His total return, in addition to any dividends received, will be the $50 exercise price he is paid for the stock plus the $4 premium collected when the option was written-$4 a share less than the $58 he could have sold the stock for if he had not written the option.
On the other hand, if the value of the underlying interest declines substantially below the exercise price, the call is not likely to be exercised and, depending upon the price paid for the underlying interest, the covered call writer could have an unrealized loss on the underlying interest. However; that loss will be wholly or partially offset by the premium he received when he wrote the option.
3. The writer of an uncovered call is in an extremely risky position and may incur large losses if the value of the underlying interest increases above the exercise price. The potential loss is unlimited for the writer of an uncovered call. When a physical delivery uncovered call is assigned an exercise, the writer will have to purchase the underlying interest in order to satisfy his obligation on the call, and his loss will be the excess of the purchase price over the exercise price of the call reduced by the premium received for writing the call. (In the case of a cash-settled option, the loss will be the cash settlement amount reduced by the premium.) Anything that may cause the price of the underlying interest to rise dramatically, such as a strong market rally or the announcement of a tender offer for an underlying stock at a price that is substantially above the prevailing market price, can cause large losses for an uncovered call writer.
EXAMPLE: An investor receives a premium of $4 a share for writing an uncovered XYZ 50 call option and the stock price jumps to $69 as the option approaches expiration. If the investor liquidates his option position at, say, $19, in an offsetting closing purchase transaction, he will incur a loss of $1 ,500 (the $1 ,900 paid in the offsetting purchase transaction less the $400 option premium received when the option was written).
The writer of an uncovered call is in an extremely risky position and may incur large losses. Moreover, as discussed in Chapter IX, a writer of uncovered calls must meet applicable margin requirements (which can rise substantially if the market moves adversely to the writer's position). Uncovered call option writing is thus suitable only for the knowledgeable investor who understands the risks, has the financial capacity and willingness to incur potentially substantial losses, and has sufficient liquid assets to meet applicable margin requirements.
4. As with writing uncovered calls, the risk of writing put options is substantial. The writer of a put option bears a risk of loss if the value of the underlying interest declines below the exercise price, and such loss could be substantial if the decline is significant. The writer of a put bears the risk of a decline in the price of the underlying interest-potentially to zero. A put writer of a physical delivery option who is assigned an exercise must purchase the underlying interest at the exercise price-which could be substantially greater than the current market price of the underlying interest- and a put writer of a cash-settled option must pay a cash settlement amount which reflects the decline in the value of the underlying interest below the exercise price. Unless the put is a cash-secured put (discussed below), its writer is required to maintain margin with his brokerage firm. Moreover, the writer's purchase of the underlying interest upon being assigned an exercise of a physical delivery option may result in an additional margin call.
A requisite for writing puts is an understanding of the risks, the financial capacity and willingness to incur potentially substantial losses, and the liquidity to meet margin requirements and to buy the underlying interest, or to pay the cash settlement amount, in the event the option is exercised. A writer of an American-style put can be assigned an exercise at any time during the life of the option until such time as he enters into a closing transaction with respect to the option. Since exercise will ordinarily occur only if the market price of the underlying interest is below the exercise price of the option, the put writer of a physical delivery option can expect to pay more for the underlying interest upon exercise than its then market value.
EXAMPLE: At a time when XYZ stock is $50, an investor receives a $300 premium ($3 a share) by writing an XYZ 50 put. Subsequently the stock price declines to $40 and he is assigned an exercise. The investor must purchase the stock at $50. Even though the $3 a share premium reduces his effective cost to $47, that is still substantially higher than the $40 market price of the stock.
The put writer's exposure to margin requirements can be eliminated if the put writer elects to deposit cash equal to the option exercise price with his brokerage firm. Under this strategy, known as cash-secured put writing, the option writer is not subject to any additional margin requirements regardless of what happens to the market value of the underlying interest. In the meantime, the option writer might earn interest by having the cash invested in a short-term debt instrument-for example, in a Treasury bill. However; a cash-secured put writer is still subject to a risk of loss if the value of the underlying interest declines.
EXAMPLE: An investor receives a $500 premium for writing an XYZ 50 put option with six months remaining until expiration and deposits with his broker $5,000 invested in Treasury bills which, over the six month option life, will earn interest of $250. If he has not been assigned an exercise by expiration, the investor will have a total return of $750 (option premium of $500 and interest of $250). On the other hand, if the price of XYZ stock were to fall below $42-1/2 and the investor is then assigned an exercise, he would have a net loss-that is, the market price of the XYZ stock he would be required to purchase would be below the exercise price by more than the combined premium income and interest earned.
5. The risk of being an option writer may be reduced by the purchase of other options on the same underlying interest-and thereby assuming a spread position-or by acquiring other types of hedging positions in the options markets or other markets. However, even where the writer has assumed a spread or other hedging position, the risks may still be significant. See paragraph 1 under "Other Risks" below.
6. The obligation of a writer of an uncovered call or of a put that is not cash-secured to meet applicable margin requirements creates additional risks. If the value of the underlying interest moves against the writer's position, or if there is a significant change in the volatility or liquidity of the underlying interest, related interests, or the option, or if the writer's brokerage firm otherwise requires, the firm may request significant additional margin payments. If those payments are not made, the firm may have the right to liquidate the options positions and other securities positions in the writer's account with little or no prior notice.
7. Since the leverage inherent in an option can cause the impact of price changes in the underlying interest to be magnified in the price of the option, a writer of an option that is uncovered and unhedged may have a significantly greater risk than a short seller of the underlying interest. This is illustrated by the table set forth in paragraph 2 under "Risks of Option Holders" above. If an investor had sold short 100 shares of XYZ to Investor A in that table in order to receive $5,000 in proceeds, the investor would have lost $1 ,200 if the market price of XYZ had increased to 62. On the other hand, if, in order to receive $5,000 in proceeds, the investor had written 10 XYZ 50 uncovered calls, he would have lost $7,000 if the market price of XYZ had increased to 62.
8. The fact that an option writer may not receive immediate notification of an assignment creates a special risk for uncovered writers of physical delivery call stock options that are exercisable when the underlying security is the subject of a tender offer, exchange offer, or similar event. A writer who fails to purchase the underlying security on or before the expiration date for the offer may learn after the expiration date that he has been assigned an exercise filed with OCC on or before that date. At that point, neither the purchase of the underlying security for regular settlement nor the exercise of another option (e.g., the long leg of a spread) will enable the assigned writer to deliver the security on the settlement date for the option exercise (see "Settlement" in Chapter VIII). If the assigned writer fails to make timely settlement, he may be liable for, among other things, the value of the offer (because his non- delivery may have prevented the exercising holder from making timely delivery of the security to the offeror). This risk can be avoided only by purchasing the underlying security on or before the expiration date for the offer. Occasionally, an offer will require that tendered securities be delivered in less than the normal settlement time for exchange transactions after the offer's expiration date. In those cases, call writers will need to purchase the underlying equity security at an earlier point-i.e., at least the number of days equal to the normal settlement time before the offeror's delivery deadline-in order to protect themselves.
9. Although the rules of the options markets establish exercise cut-off times by which exercise instructions of expiring options must be received by brokerage firms from their customers, OCC must accept all exercises which it receives before expiration, even if those exercises are filed with OCC in violation of an options market's rules. Accordingly, there is a risk that an option writer will be assigned an exercise that is made based on news that is published after the established exercise cut-off time and that the writer may not have an effective remedy to compensate for the violation of the options market's rules.
10. If a trading market in an option should become unavailable, or if the writers of the option are otherwise unable to engage in closing transactions, the writers of that option would remain obligated until expiration or assignment. See the discussions in paragraphs 2 and 3 under "Other Risks" below.
11. A sudden development may cause a sharp upward or downward spike in the value of the interest underlying a capped option. Such a spike could cause the capped option to be automatically exercised, and writers of the option to become obligated to pay the cash settlement amount, even if the effect of the development on the value of the underlying interest completely disappears on the day after the automatic exercise is triggered.
OTHER RISKS
1. Transactions that involve buying and writing multiple options in combination, or buying or writing options in combination with buying or selling short the underlying interests, present additional risks to investors. Combination transactions, such as option spreads, are more complex than buying or writing a single option. And it should be further noted that, as in any area of investing, a complexity not well understood is, in itself, a risk factor. While this is not to suggest that combination strategies should not be considered, it is advisable, as is the case with all investments in options, to consult with someone who is experienced and knowledgeable with respect to the risks and potential rewards of combination transactions under various market circumstances.
The investor considering strategies involving combination transactions should recognize several other risk-related considerations in addition to those already mentioned: the fact that it may at times be impossible simultaneously to execute transactions in all of the options involved in the combination, the difficulty that may be involved in attempting to execute simultaneously two or more buy or sell orders at the desired prices, the possibility that a loss could be incurred on both sides of a combination transaction, and the increased risk exposure that would result from the exercise or closing out of one side of the trade while the other side of the trade remains outstanding. Also, the transaction costs of combination transactions can be especially significant, since separate costs are incurred on each component of the combination. This can have the effect of requiring a substantial favorable price movement in the underlying interest before a profit can be realized.
Where a combination transaction involves the writing of an in the money American-style option, an investor must keep in mind the possibility of being assigned an exercise, which would eliminate that component of the transaction and could materially change the investor's risk position.
In the case of straddle writing, where the investor writes both a put and a call on the same underlying interest at the same exercise price in exchange for a combined premium on the two writing transactions. the potential risk is unlimited (except in the case of capped options). To the extent that the price of the underlying interest is either below the exercise price by more than the combined premium, or above the exercise price by more than the combined premium, the writer of a straddle will incur a loss when one of the options is exercised. Indeed, if the writer is assigned an exercise on one option position in the straddle and fails to close out the other position, subsequent fluctuations in the price of the underlying interest could cause the other option to be exercised as well, causing a loss on both writing positions.
Combinations involving different styles of options present added complexities. For example, the assigned writer of an American-style option would be unable to cover by exercising a European-style or capped-style option that he holds unless the assignment happened to occur during the exercise period of that option.
Combination transactions involving all cash-settled options also pose the same risks that are discussed for index options under "Special Risks of Index Options" below.
2. If a trading market in particular options were to become unavailable, investors in those options could no longer engage in closing transactions. Moreover, even if the market were to remain available, there may be times when options prices will not maintain their customary or anticipated relationships to the prices of the underlying interests and related interests. The options markets attempt to provide secondary markets in which holders and writers of options can close out their positions at any time prior to expiration-by making offsetting sales or purchases-but there is no guarantee that such a market will at all times exist for every option. Lack of investor interest, changes in volatility, or other factors or conditions might adversely affect the liquidity, efficiency, continuity or even the orderliness of the market for particular options. Or an options market might permanently discontinue trading of a particular option or of options generally (although it has ordinarily been the practice, when an options market decides to discontinue trading of options on a particular underlying interest, to do so only after all outstanding series of those options have expired if the options are not traded on another options market). A market could become temporarily unavailable if unusual events-such as volume in excess of trading or clearing capability, computer malfunction, fire or natural disaster-were to interrupt normal market operations. As discussed in paragraph 3 below, an options market may also become unavailable in the event trading in the underlying interest is formally suspended or halted. It is also possible that an options market will not open, or will delay opening, trading in certain options even though trading is taking place in the underlying security (or in the constituent securities of an underlying index).
In addition, an options market may at times determine to impose restrictions on particular types of options transactions, such as opening transactions or uncovered writing transactions. For example, if an underlying interest ceases to meet qualifications imposed by the options market or OCC, new series of options on that interest may no longer be opened to replace expiring series, and opening transactions in existing series may be prohibited.
The accounts of options market makers and specialists are carried and guaranteed by a relatively few firms. If one of these firms were to fail, be suspended by OCC, be restricted in its operations, determine or be required to discontinue or reduce its operations, or have a significant reduction in its capital, the markets for particular options, or even for all options, could be disrupted or possibly forced to discontinue trading.
Similarly, in the event an options specialist or a significant group of options market makers should fail or have a significant reduction in capital, the markets in the particular options in which the specialist or market makers traded could be adversely affected. The suspension by OCC of any Clearing Member that maintains significant positions in a particular options series in its accounts could also disrupt the market for that options series.
An options market could also become unavailable because of its own financial problems. For example, if an options market were to be declared bankrupt or if creditors were to take possession of its principal trading systems, it might be unable to continue to operate as an options market.
If a secondary market in a particular option were to become unavailable, a holder of that option would be able to realize his profits or limit his losses only by exercising at a time when the option is exercisable, and a writer of that option |
