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Limitations of Options
While options can be used as an effective tool for hedging and speculation, by nature they are highly complex and require a great deal of observation and attention. You have to be careful in not only predicting the movement of the market direction, but also the magnitude and timing of this movement. You should keep the following points in mind while building any option strategy. Costs Compared to trading stocks, the cost of trading options is significantly higher on a percentage basis and it can drastically eat into profits. The buyer of an option may end up loosing the entire premium paid if he simply lets the option to expire. While the market may move in the direction anticipated by the buyer, it is important to remember that options have a limited life span and hence, the magnitude of the expected rise or fall of the share price may not justify the premium paid.
Unlimited losses Some option writing strategies can expose a writer to theoretically unlimited loss. As mentioned in the advantages of options, the writer of a call option may face the risk of unlimited losses, if he is not holding the underlying asset at the time the contract expires. Assume that an option writer has sold a call option with a strike price of $50 and the market price on the date of expiration reaches $60 due to unforeseen circumstances. In this case, if the writer is not holding the underlying shares, he will end up loosing $10 per share, since he will have to purchase those shares at $60. This loss can increase substantially since there is no limit to how high a stock can go.
Liquidity A buyer of an out of money call option can always sell the option before the expiration date to recover a portion of premium paid, instead of letting the option expire and loosing on the entire premium. However, it is important to remember that the liquidity of the option depends on the liquidity of the underlying stock. For a holder of an illiquid option, it may be difficult to close his position before the expiration day incase the market moves against his predictions. An indicator of the liquidity of an option is the total number of option contracts currently open (Open interest). While this number represents the number of options that have been traded, it does not specify the number of options exercised, sold or closed. Never the less, a change in the open interest indicates whether the trading volume is high or low. The larger the open interest, the more liquid the option. Volatility An option being a derivative instrument, depends on the price of the underlying shares that it is attached to. Also the option price is more volatile than the price of the underlying shares. An option that is in-the-money today can be out-of-money tomorrow due to unforeseen circumstances.
American Options can be exercised before their expiration date As stated in Different Types of Options, American options can be exercised at any time prior to the expiration date. The writer of an American option faces a risk of significant losses if he does not have the underlying shares at the time that the option is exercised. The writer should also be aware that certain events can trigger an early exercise of options. For instance, the market price of a company tends to go down after the ex-dividend date and the holder of an American put option can choose to exercise their option at this point.