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.

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Neutrality

The underlying stock can do one of three things when you buy an option.

1. It can move in the direction that you believe it will. If it does, then there is a good chance you will get a return on your investment.

2. It can move in the opposite direction. If that happens, you may lose the full value of your investment if you don’t get out in time.

3. The stock can go into a holding pattern. If the stock price remains basically neutral, your option could expire worthless because of time decay. (Keep in mind that this is applies to out-of-the-money (OTM) options. If the option is still in-the-money (ITM), there is still value to be realized in the option or by exercising it.)

In some instances, the option may lose value even if the underlying stock is going in the direction you hoped it would. This is because the value of the time loss exceeds any increase in the value of the option due to changing stock prices.

This is where stocks and options diverge significantly. Where stocks will still hold some value in neutral and declining markets, options stand to lose all their value.

Inaction

When you buy an option, the purchase price is non-refundable. You can only make a return on your option if you sell it before its expiration date or exercise the option.

Failure to act before the expiration date (the third Friday of every month), means an out-of-the-money option expires worthless and you lose everything you invested.

And some investors have lost money even when their option was profitable because they failed to act before the expiration date or exercise their option. (Some stock brokers will now automatically exercise your option and purchase the underlying stock on your behalf provided that there is profit in it for you.)

Although you may fail to sell a stock at its most-profitable moment, it can still have some inherent value, whereas out-of-the-money options lose their value at expiration.

Even if your stock is moving in the wrong direction, it is possible to recoup some of your losses by selling the option prior to expiration. However, you will often only get pennies on your dollar investment.

Now that you clear on the risks, make sure to check out my article on the top seven reasons every investor should be trading options. Your portfolio will thank you!